Standard Costs: Setting, Variance Analysis, and Benefits

1. May 25, 2009 Standard Costs

2. Today’s Agenda • What is Standard Cost and what is its purpose? • How are they set? • Direct Material Standard • Direct Labour Standard • Variable Overhead Standard • Standard Cost versus Actual Cost • Variance Analysis • Benefits and Problems with Standard Cost

3. Standard Cost • Standard Costs are benchmark costs that management believes are appropriate for measuring performance • Quantity Standards • How many units of an input should be used to produce a unit of output • E.g., it should take 20 minutes of Direct Labour to produce one cell phone • Price Standards • What is the appropriate price of a unit I • E.g., an hour of labour should cost $5 • In this case, the Direct Labour Standard is .33 * 5, or $1.67 per unit

4. Standard Cost • Standard Cost information is used for several purposes: • Budgeting • Build up of expected appropriate costs are input into budgets • Monitoring costs • Budgets are tracked on a regular basis • Controlling costs • With budgeted inputs in place, managers are incentivized to work to and exceed targets • Isolating problems • When compared to actual costs, it is helpful in identifying problem areas and isolating the source

5. Variance • Deviations from Standard Cost are called “Variances” • Variances can be “Favourable” or “Unfavourable” • In the case of the cell phone manufacturer, any Direct Labour cost per unit which is • above the Standard Cost of $1.67 would be described as an Unfavourable Variance • Below the Standard Cost of $1.67 would be described as a Favourable Variance • Managers can focus in particular on Unfavourable Variances • There could be a problem in the production process • There could be a problem with the application of the methodology

6. Takecorrective actions Identifyquestions Receive explanations Conduct next period’s operations Analyze variances Variance Analysis Cycle Prepare standard cost performance report Begin

7. Who Sets Standard Costs • Setting appropriate Standard Costs requires the input of several people • Purchasing Managers • Pricing of Direct Materials • Production Managers • Quantity of Direct Materials • Required Labour • Engineers • Optimizing processes and determining impact on Standard Cost • Accountants • Verification • Calculation and monitoring • Exception reporting • As managers will be held to account for Variances, therefore Standard Costs should be “reasonable” and achievable • Additional incentive can be provided for reducing costs, designing out high value parts and processes, etc.

8. Standard Costs Objects • Direct Materials • Quantity Standard • Quantity or each component required • Lead times – impacts inventory financing costs (as apposed to standard cost) • Price Standard • Price of the components at the volume required • Net of discounts, shipping etc. – “landed cost” • Direct Labour • Time Standard • Time required from Direct Labour to “Convert” the Direct Materials into a Finished Product • Rate Standard • Variable Manufacturing Overhead • Price Standards • Quantity Standards

9. Standard Cost Card – Variable Production Cost • A Standard Cost Card is produced for each SKU

10. Price Variance Quantity Variance Difference betweenactual price and standard price Difference betweenactual quantity andstandard quantity A General Model for Variance Analysis Variance Analysis

11. Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Quantity Variance A General Model for Variance Analysis (AQ × AP) – (AQ × SP) (AQ × SP) – (SQ × SP) AQ =Actual Quantity SP =Standard PriceAP =Actual Price SQ =Standard Quantity

12. General Variance Analysis Applied • Assumptions: • Standard Rate = $104 • Standard Quantity = 1,000 • Actual Quantity = 900 • Actual Cost = $110,000 • What is the Price and quantity Variance?

13. General Variance Analysis Applied • Actual Rate = 900 units / $110,000 = $122 • Price Variance = 93,600 – 110,000 = -$16,400 (unfavourable) • Quantity Variance = 104,000 – 93,600 = $10,400 (favourable)

14. Detailed Variance Analysis Applied • Variance Analysis is applied in the same way for detailed accounts as it is in general • Direct Materials, Direct Labour, Variable Overhead • Direct Materials Variance • Assume: • Standard Quantity = 5,000 pieces (5 pieces x 1,000 products) • Standard Rate = $10 per piece • Actual Quantity Used 4,500 pieces • Actual Cost = $60,000

15. Detailed Variance Analysis Applied • Actual Rate = $13 per piece ($60,000/4,500 pieces) • Price Variance = -$15,000 unfavourable • Quantity Variance = $5,000 favourable

16. Tutorial • Assignment • Study Review Problems • Prepare for Group Project Final Section