Standard Costs and Variances - Research Paper Example

Standard cost and variances xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx ID No. Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Lecturer xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date 1.0 Executive summary Standard costs and variances are very important control tool for any organization or firm. They help in proper planning before operations start. Standard costs and variances help to correct mistakes and keep operations in the right direction as planned by the management. Variances in specific aid the management in rectifying areas they went wrong and predicting the earnings they will make. Variances and standard costs are an important control and management tool for any organization. It is prudent for any organization at any time to have these two in control and management of its production department and organization as a whole. Table of Contents 1.0 Executive summary ii Table of Contents iii 2.0 Introduction 1 3.0 Statement of the research 1 4.0 Objectives 1 5.0 Theoretical framework 2 6.0 The standard costs and variances 2 6.1 Standard cost systems 2 6.0 Direct labor and material variances 3 6.2.1 Direct labor 3 6.2.2 Labour cost variance 4 6.2.3 Labor rate variance 4 6.2.4 Labor efficiency variance 4 6.2.5 Labour idle time 5 6.3 Material variances 5 6.3.1 Material price variance 5 6.3.1 Material quantity variance 6 6.4 Overhead Variances 6 6.4.1 Fixed variance 6 6.4.2 Variable Overhead Variance 7 6.5 Cost of quality 8 6.5.1 Prevention costs 8 6.5.2 Appraisal costs 8 6.5.3 Internal failure costs 8 6.5.4 External failure costs 9 6.6 Balanced score card. 9 6.6.1 The financial perspective 9 6.6.2 The learning and growth perspective 10 6.6.3 Business process perspective 11 6.6.4 The customer perspective 11 6.7 Activity based costing (ABC) 12 6.7.1 Estimating the cost per time unit of capacity 12 6.7.2 Estimating the unit times of activities 13 6.7.3 Deriving cost driver rates. 13 Conclusion 13 Recommendations 13 References 14 2.0 Introduction Standard costs and variances are mostly used in the production department of a firm. Standard costs are the budgeted figures that a company prepares before the start of the production activities, prepared so that the management can know how much it needs for its production to be continue. This will help in avoiding inconveniences during the production process. It will also help to know how much the management needs in terms of fund and to source for the materials needed for production. Variances on the other hand are the control tools used by the management to correct deviations from the budgeted costs. They are the difference between the actual results and what was planned for (standard/ budgeted costs). The actual results may be higher or lower than the budgeted costs creating a variance. It is this variance that the management investigates and takes the necessary actions towards the same. Variances are caused by different things like machine break down in the process of production, power failure, inflation in the market, natural calamities (earthquake, floods), difference in personnel, abrupt changes in the production plants among other causes. If actual results are higher than the standard/budgeted results the variance is called unfavorable or adverse. It the standard/ budgeted are higher than the actual results the variance is favorable. Adverse variances call for action by the management to amend and change in the method of operation in respect of that variance. 3.0 Statement of the research The research endeavors to bring out an in-depth insight of on the theories existing on costs and variances and their practicality in real life situation in organizations. 4.0 Objectives The aims of this report are: To understand the standard costs and variances. To investigate the causes of variances. To look in to detail the purpose of standard costs and variances in an organization. To understand the importance of budgets and variance. To provide a good learning tool. 5.0 Theoretical framework Variances and standard costs are management and control tools used by the management. They are very practical in their application. However this will only remain theoretical if firms do not practice to adopt and implement them as costs control tools for their operations. Many are the organizations that use standard costs and variances in their operations. 6.0 The standard costs and variances 6.1 Standard cost systems Standard cost systems are methods that are employed in the setting of cost targets as well as evaluating performance (Fredin & Venkatesh, 2010). Targets are the expected costs. Their setting is based on a number of criteria together with the actual performance that is relative to the targets that are expected and how they are to be measured. Standard cost systems help managers to make decisions effectively and also to ensure good control of an organization. Standard costs systems are utilized during the process of budgeting and the analysis of variance. Standard costs, for example those of the needed material, the labour and even administration are always identified in time (Fredin & Venkatesh, 2010). Target costing which is the market price of products influences and determines the price in which future products will be sold (Fredin & Venkatesh, 2010). For a company to set its product selling prices, it depends much on the target costing, that is, the market price. Target cost is therefore the difference that exists between selling prices and profit margins. There are several reasons for using standard cost systems. First of all, standard cost systems help in making decisions (Baste et al, 2010). The managing directors are in a position to consider to products will be produced. Knowing the demand level in the market, the number of products to be produced may be increased or reduced. Still, Fredin & Venkatesh (2010) argue that the pricing of products is made easy. This is because the supply and demand of products is established and analyzed. A Standard system also helps in the monitoring of product manufacturing. In such circumstances, standard costing provides standard costs that are used in the analysis of variance. A comparison is drawn between the standards and the actual results achieved so far. If there are large variances in the system, these may be indications that the production is encountering problems. Standard costing systems also give the standard cost which is employed in budgeting and planning for performance in the future. Though unforeseen, the period of time that is set determines if the costs will be high or low depending on the present trends and other factors that determine the price of products (Bastl et al, 2010). Moreover, such standards can be used in communicating to employees in an organization about economy as well as efficiency towards the achievement of the business objectives. Still, employees can be motivated into achieving the required performance level thus overcoming the wastage of time or the attainable standards (Bastl et al, 2010). 6.0 Direct labor and material variances These are valuable management tools for accounting for labor and materials that a company uses in the process of manufacture and or production process. Labor and materials account for a large part of the total cost of the product. They help the management to be aware of the differences of the manufacturing costs between the planned (budgeted) and the expected (actual) costs. They are favorable if the actual costs incurred in the manufacture are less than the standard costs while for unfavorable the actual is greater than the standard. Unfavorable variance indicates to the management that the actual profits will be less than the planned profits. Favorable variance indicates that the actual profits will be higher than the planned profits. This therefore must be accounted for properly to avoid inefficiency that may crop in the process of production and wastage of raw materials. It is better for the management to detect variances as soon as possible so that it can take the necessary action to avoid variation from the planned amounts. 6.2.1 Direct labor Direct labor variances have a number of variance, the labor rate variance and labor efficiency variance. There is also the idle time variance. 6.2.2 Labour cost variance This arises out of the difference between the standard costs of direct labour (specifically designed for production) and the actual direct wages that has actually been incurred. It is divided in to two, the rate variance and the efficiency variance. 6.2.3 Labor rate variance It arises between the difference of the actual pay rate and the standard rate of pay multiplied by the actual hours of work. It is calculated as follows, LRV = Actual Hours x (standard rate – actual rate) Labor rate variance may occur due to using different grades of labor between technical specifications and production process, using below or above standard rates during emergency or seasonal periods, paying workers who have guaranteed pay or those unable to establish stable piece rates, hiring new workers in the process of production therefore altering the standard budget and favoritism by supervisors in promotion of workers to a higher grade and rates. 6.2.4 Labor efficiency variance This arises from the difference between expected efficiency and actual efficiency. It’s calculated as follows; LEV = Standard Rate x (standard hours of actual output – actual output). This variance occurs because of changes in production method, machine break down in the process of production, purchase of more efficient machineries, replacement of lazy workers with more efficient employees, un availability of raw materials and repeat of production process for spoilt products. Illustration A particular job has the following information Actual wages per hour $7 Actual hours 110 hours Standard wages per hour $ 6 Standard hours 160 hours Costs variance: standard cost – actual cost (160 x $6) – (110 x $7) = 960 – 770 = $190 favorable Rate variance: standard rate – actual rate 110 x (6-7) = 110 unfavorable Efficiency variance; standard hours – actual hours 6 x (160 - 110) = 300 Favorable Therefore labour cost variance = rate + efficiency= 300 – 110 = 190 6.2.5 Labour idle time This occurs due to abnormal circumstances like lock outs, machine breakdowns, strikes, power failure. This results in wastage of time since workers are not working. However this does not occur due to employee’s inefficiency. This variance is always adverse, calculated as the standard rate multiplied by the idle hours (tutor, 2009-2011). 6.3 Material variances This are the direct materials that can be directly traced in to the production process. Material variances consist of; 6.3.1 Material price variance This is calculated as MPV = (AP - SP) AQ where AP is the actual price of the materials. SP is the standard price of the materials AQ is the actual quantity of the purchased materials The price variance is favouable if the actual price is less than the standard while the opposite means that the actual price is higher than the standard price which then is unfavourable. 6.3.1 Material quantity variance This is the amount of materials that is purchased for production. This is very important to any company as material dertemine how work will be done like the idle time. It is calculated as MPV = SP (AQ - SQ) where SP is the standard price of the materials per unit AQ is the actual quantity of the produced output SQ is the standard quantity allowed for produced output When actual quantity is greater than the standard quantity the results are adverse and favourable when the standard quantity is greater than the actual quantity produced. 6.4 Overhead Variances Overhead variance is the differences between the actual overhead variances and the absorbed variances. Actual overhead variances are the variances that are acquired and are identified at the end of accounting period after the accounts preparations. Absorbed overheads are the overheads that are charged to a good on a prearranged overhead rate, which is also the standard overhead absorption rate. Variances are calculated for every production cost, direct material, direct labor, variable overhead and fixed overhead. There are two types of overhead variance, fixed variance and variable overhead variance. 6.4.1 Fixed variance Fixed overhead variance is the variation between the amount of fixed overhead essentially practical to products produced founded on production volume, and the sum that was budgeted to be applied to the goods produced. Some of the examples of fixed overhead costs includes, company rent, insurance on production facilities, depreciation of equipments, utilities as well as the salaries of production supervisors and support staff (Strand et all, 2013). Possible causes of variances One of the possible causes of fixed variance in the company is the change that happens in the production systems. This may be caused by the introduction of automation, Just-in-time systems, cellular manufacturing and so on. This may call for a revision on fixed overhead allocation to the companies that allocate the fixed overhead yearly to monthly basis (Accounting tools, 2013). Second possible cause of fixed variance is the change in the actual amount of the allocation base that differs from the sum built into the budgeted allocation rate. This sources the fixed overhead volume variance. For instance, a company may budget for the allocation of $50,000 of fixed overhead costs to produce products at the rate of $100 per unit produced, with the anticipation that 500 units will be made. Nevertheless, the actual quantity of the produced units is 700, so a total of $70,000 of fixed overhead costs are apportioned. This creates a fixed overhead variance of $20,000. The fixed overhead costs that are an element of this variance are generally contained of only those fixed costs which incurs in the procedure of production 6.4.2 Variable Overhead Variance Variable overhead variance is the difference between the actual and the rate of spending budgeted on variable overhead. The diverse is used to center the concentration on overhead costs that differs from the anticipations (Boyd, 2013). The calculating formula is as follows, Actual hours worked x (Actual overhead rate –standard overhead rate) =Variable overhead variance. Possible causes There are numerous possible causes of variable overhead variance. The first one is account misclassification. Since the variable overhead group includes various accounts, a number of them may have been wrongly classified and so may not come out as component of variable overhead, or it might be vice versa. In addition, some of the activities that might have been sourced by the company can be shifted to a supplier or it may happen vice versa. On the other hand, suppliers may change the prices of their products, which might have been not reflected in the restructured standards (Accounting tools, 2013). 6.5 Cost of quality Cost of quality is the cost that a company incurs as a result of not creating quality products or services. It is important to highlight that cost of quality is not the cost that the company will incur in the process of producing a quality product or service as is widely misconstrued. Failure to meet the quality standards of a product or service means that the work has to be redone giving rise to cost of quality. Quality costs can be classified into various categories namely prevention, appraisal, internal and external costs. 6.5.1 Prevention costs These are the costs that a company incurs in its efforts to prevent production of poor quality products and delivery of poor quality services. It is product of very management to institute measures in the production and service delivery chain that will check the quality of services and products from the start through the middle and the final results to ensure that that compliance with standards is maintained. Activities that will give rise to prevention costs are audit reviews, risk management, quality planning, education and training among others. 6.5.2 Appraisal costs Appraisal cost refers to the cost incurred by the company in course of determining the degree of conformity to quality standards in the production of goods and service delivery. The appraisal process entails measuring the level of conformity with the standards, evaluating the results against the standards to determine variance and employing corrective measures to ensure that variance the s do not recur again in the production process. The specific activities that give rise to appraisal cost include inspection testing, service and process audits as well as the cost of equipment involved in the testing process. 6.5.3 Internal failure costs Internal failure costs are costs that are associated with defects of the products before they are delivered or shipped to the customer. This is the sum total of the labour, material and overhead costs that were incurred in production of the defective goods or services. The specific costs associated with internal failure costs are scrap, cost of rework, re-inspection, re-testing, downgrading and material review. 6.5.4 External failure costs This refers to the costs that are associated with delivery of a defective product or service to the customer. These costs arise from the action of the company shipping or delivering products or services that fail to meet the quality standards and therefore the products have to be shipped back or the customer may institute legal proceedings against the company. The specific activities and costs that give rise to this external failure cost include lost sales, warrant claims, shipping costs, legal battles, and repairs among others. This category of costs has the highest cost implication to the company as it may affect even its future business by creating a negative image about the company’s products. The total cost of quality is the summation of the above four categories of cost minus the cost that would have actually been incurred if there were no defects in the production of goods or services. 6.6 Balanced score card. This can be defined as an approach to measurement of the company’s performance that takes into account both the financial as well as the non- financial aspects of the company’s performance. It is a shift from the traditional methods of measuring the company’s performance that only took into account the financial performance and neglected other issues that are important in meeting the organization’s goals and objectives. The term balanced score card was initially coined by Drs. David Norton and Robert Kaplan and has evolved over the years to not only be a measure of performance but rather a strategic planning and management system that helps managers translate their strategic documents in to achievable action plans. The balanced score card according to Kaplan (pg 4) suggests that an organization should be viewed in four perspectives and data should be collected and analyzed in relation to each perspective. The four perspectives are as shown in diagram 1 below and are discussed as follows. 6.6.1 The financial perspective Every organization must keep track of all its financial data and this data must be analyzed so as to gain meaningful sense from the data. To keep proper financial data, the company should invest in book keeping proper accounting to ensure that all financial aspects of the organization are captured. This information should thereafter be analyzed as financial results and reports, cash flow statements, return on investment, return on capital employed and any improvements instituted to ensure that the overall financial objectives of the organization are achieved. Cost benefit data as well as risk assessment should as well be included as part of the financial perspective. 6.6.2 The learning and growth perspective The management of the company must ensure that at all times there is adequate number of employees who are well trained to deal with their respective tasks effectively. Proper metrics must be in place to guide the management on the areas that the employees require additional training and hence channel the company resources to ensure that the company has a work force that is equal to its tasks at all times. Companies are operating in an environment of ever changing technologies and as such a laxity in equipping the employees with knowledge of the latest relevant technologies will result to underperformance and failure to meet the overall goals and objectives of the company. The management should also be concerned about the rate of employee turnover which could be closely related to lack of job satisfaction which can easily result to failure to meet the organization goals. 6.6.3 Business process perspective This perspective entails the role of management in determining whether the business of the company is still on track and whether its products and services conform to the basic standards set and as well whether they meet the customers’ expectations. Proper metrics must be instituted by people who have a clear understanding of the company’s business as well as its mission and strategic plans. These metrics will measure performance as well as be used to eliminate the high number of activities per process, remove duplication of activities, align processes to their right departments and personnel and remove bottlenecks and extensive bureaucracies as well as instituting automation of the company’s processes and procedures. 6.6.4 The customer perspective The modern day businesses have come to appreciate the role of customers in the success of any business. Traditionally, businesses paid more attention to costs in production process and ignored the element of customer satisfaction which is very key in ensuring that the organizations overall goals are made. Metrics under this perspective will measure how a company performs in terms of delivery of its services and products to customers, quality of services and products delivered, how well the company retains its current customers as well as the market share of customers by the company in the particular industry it operates in. Data relating to the above must be properly captured and analyzed and any improvements required instituted immediately hence ensuring that the company remains well on course to meeting its overall goals and objectives. 6.7 Activity based costing (ABC) This is a method of assigning costs and especially the overhead costs to products or services based on the resources that they consume during the manufacturing process or the delivery process (Akyol et al, pg1). This is an alternative to the traditional cost allocation methods where the overhead costs are allocated to an activity in relation to the direct costs that the activity incurred (Cardos & Pete, pg154). A closer analysis of this traditional approach has exposed one major weakness of this approach based on the fact that two activities may consume the same amount of direct costs but end up using different overheads. This is the gap that the activity based costing seeks to eliminate by ensuring that the cost of overheads allocated to an activity are actually equal to the amount of overhead cost the activity consumes in course of it production. Activity based costing seeks to determine the activities involved in the production process of a product or service and then allocates costs to this activities. The costs allocated to these activities then form the basis of assigning cost to the product produced with the aim of ensuring that these costs are as close as possible to the cost of overheads consumed when producing the product. To deal with the complex nature of activity based costing, a simpler method has been developed which is known as time-driven ABC. Under this approach, three steps are important namely estimating the cost per time unit of capacity, estimating the unit times of activities and finally deriving the cost driver rates. A hypothetical example is where a company has 10 customer service employees earning a monthly salary of $ 15,000 and the theoretical monthly time worked is 1,920 hrs. To arrive at standard cost rates that will be applied to each customers during transactions, the following steps will be followed. 6.7.1 Estimating the cost per time unit of capacity The practical position is that the employees will be productive for about 80% of the theoretical time meaning the practical capacity is 1,536 hrs. To arrive at the cost per unit of capacity the monthly cost/ salary of the employees will be divided by the practical capacity to give rise to $ 9.8. 6.7.2 Estimating the unit times of activities The next step is to determine how much time is spent in a unit of each kind of activity. Estimates of this can be obtained through observation as activities are proceeding or through interviews to the employees. In case of the above example the management may establish that it takes 5 minutes to process an order, 10 minutes to deal with inquiries and 30 minutes to do debt collection and this will lead to the next step. 6.7.3 Deriving cost driver rates. The cost driver rates will be obtained by multiplying the above two variables of cost per time unit of capacity and unit times of activities for each activity. The cost driver rate for processing orders will be $ 49, for dealing with inquiries will be $ 98 and that of debt collection will be $ 294. These standards rates can now be applied in real life situations any time the company is handling customers and transactions. Conclusion Cost is a key element in the success of any organization and therefore devising an appropriate system that helps in capturing cost relating to production of products or services is a key priority of any successful organization. Overhead costs in any organization provides a challenge to the management on the best way to allocate them to the units produced in the most appropriate yet cost effective manner. Standards are therefore developed to help in the allocation of the overhead costs and it at this point of development that the management has to make an important decision as to the best system of developing the standards. Historical systems have been faulted for making assumptions that end up not ensuring that costs are allocated to units of production in the most appropriate manner as discussed above and hence the need to use the modern systems like the activity based costing. Recommendations Whichever systems that the company decides to implement, the system should allow for proper measurement of results, evaluation by comparing with set standards so as to determine variances and institute corrective measures immediately so as to ensure that variances are not reported again. Modern environment of doing business dictates that the quality of products and services being produced and offered must be of the right quality and standards and must meet the expectations of the customer as failure to do so will amount to the company incurring huge costs of quality. It is therefore prudent to institute control mechanisms in course of the production process to ensure any deviations from the expected results are detected and rectified on a timely basis. References Accounting tools. (2013, November Sunday). CPE for CPAs. Retrieved from http://www.accountingtools.com/questions-and-answers/what-is-the-fixed-overhead-volume-variance.html Akyol, D., Tuncel, G., & Bayhan, G. (2007). A comparative analysis of activity- based costing and traditional costing, world academy of science, engineering and technology, Vol. 3, Pp 580-583. Bastl, M., Grubic, T., Templar, S., Harrison, A., & Fan, I. S. (2010). 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