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to: Outline the nature and purpose of an operational control system and the role of budgets, standards and variances. Explain how standard costs are set and define basic, ideal and currently attainable standards Compile flexible budgets and from these calculate labour, materials overhead and sales variances and reconcile actual profit with budgeted profit Identify the causes of variances and discuss the factors leading to the decision to investigate variances Discuss the limitations of traditional standard costing systems and assess alternatives
Essential Reading Drury Chapters 12, 15 and 16 (pages 461 and 468482) Drury C (1999) Standard costing: a technique at variance with modern management?, Management Accounting, November Graham C, Lyall D and Puxty A (1992) Cost control: the managers perspective Management Accounting, October Kaplan RS and Norton DP (2000) The Balanced Scorecard Measures that Drive Performance. Harvard Business Review, January-February, pages 71-79. Recommended Reading Gowthorpe: Chapter 18 Atrill and McLaney, Chapter 7
2. Identify potential courses of actions (i.e. strategies) Long term planning process
Feedback control Steps are taken to get operations back on track as soon as there is a signal that they have gone wrong (see above) Feed forward controls Predictions are made about what could go wrong and then steps taken to avoid that outcome e.g. in the preparation of budgets
Standard and actual costs compared and variances analysed and reported
Standards monitored and adjusted to reflect changes in standard usage and/or prices
Flex the budget for changes in activity level (changes in units of output) Calculate the differences between budget and actual output these are termed variances Reconcile the original budgeted profit and actual profit Relationship between the budgeted and actual profit (McLaney & Atrill 2002, page 398) Budgeted profit
plus
Actual profit
These are predetermined costs. They are target costs that should be incurred under efficient operating conditionson a per unit basis (Drury, 2005, page 340)
Standard costing is most suited for organisations where the activities are common or repetitive. The examples we shall use will be for manufacturing organisations.
Types of cost standard (Drury 2005, pages 346-347) Basic cost standards Left unchanged over long periods of time. Helps to establish efficiency trends. Seldom used, as they do not represent current target costs, so not very useful for control.
Ideal Represent perfect performance. standard Minimum costs under the most s efficient operating conditions. Can be demotivating and unlikely to be used in practice. Currently attainable standards
Costs that should be incurred under efficient operating conditions. Difficult, but not impossible, to achieve. Can be set at various levels of difficulty.
Numerical Example
(adapted from Newman 2002, ignores idle time variances)
Original budget data (using standard costs) Sales Direct materials Direct labour Variable production overheads Fixed production overheads Budgeted profit 4,000 units @ 50/unit 5kg per unit @ 3/kg 2 hours @ 8/hr 2 hours @ 1/hr 2 hours @ 2.50/hr 200,000 (60,000) (64,000) (8,000) (20,000) 48,000
Actual data for the period Sales Direct materials Direct labour Variable production overheads Fixed production overheads Budgeted profit 4,150 units 21,250kg 8,250 hours 205,425 (61,350) (68,500) (8,225) (19,000) 48,350
Original Budget (4,000 units) Sales Direct materials 4,000 x 50 = 200,000 5kg x 4,000 units = 20,000kg x 3 = 60,000 2hrs x 4,000 = 8,000 hours x 8 = 64,000 8,000 hours x 1 = 8,000 20,000 48,000
Variance s
Direct labour
Difference between Original Budget Profit and Flexed Budget Profit = Sales Volume Variance (Drury calls this the sales margin volume variance)
Difference between Flexed Budget Sales and Actual Sales = Sales Price Variance (Drury calls this the sales margin price variance)
Difference between Material Flexed Budget and Actual Materials = Total Direct Materials Variances Can be broken down into: Materials Price Variance and Materials Usage Variance Material Price Variance: What did we pay for the quantity of materials we actually bought compared to what we had budgeted for? We bought (in kg): We paid: We would have expected to pay: Variance =
Materials Usage Variance: How much materials did we use compared to what we thought we should have used? Work this out at budgeted costs. We used: We expected to use: This is a kg difference Work this out at budgeted cost per kg =
Difference between Labour Flexed budget and Actual Results = Direct Labour Variances Can be broken down into: Labour Rate Variance and Labour Efficiency Variance Labour Rate Variance: What did we pay for the hours we actually used compared to what we had budgeted for?
Labour Efficiency Variance: How much labour did we use compared to what we thought we should have used. Work this out at budgeted costs.
Difference between Variable Overheads Flexed budget and Actual Results = Variable Overheads Variance Can be broken down into: Variable Overhead Expenditure Variance and Variable Overhead Efficiency Variance (This breakdown is not always done, but the technique is the same as for the labour variances, see Drury. In the Workshop example this variance is not broken down)
Difference between Fixed Overheads Flexed budget and Actual Results = Fixed Overhead Expenditure Variance
Operating Statement (reconciliation of profit) Original budgeted profit + Sales volume variance = Flexed budget profit Sales price variance + Materials price variance - Materials usage variance - Labour rate variance + Labour efficiency variance + Variable overhead expenditure variance + Fixed overhead expenditure variance = Actual profit
Favourable
48,000
Add favourable variances: Sales volume variance Materials price variance Labour efficiency variance Variable overhead expenditure variance Fixed overhead expenditure variance
Less adverse variances: Sales price variance Materials usage variance Labour rate variance
= Actual profit
PURPOSES OF STANDARD COSTING (Drury 2005, pages 347-348) Providing a prediction of future costs that can be used for decision-making purposes Providing a challenging target Assisting in setting budgets Acting as a control device Simplifying the task of tracing costs to products for profit measurement and inventory valuation
Should variances always be investigated? (McLaney & Atrill 2002) Significant adverse variances may indicate a fault that could prove very costly Cost-benefit analysis keep insignificant variances under review Significant favourable variances should also be investigated (McLaney & Atrill say probably) Note the concentration on adverse variances in McLaney & Atrill (2002)
REASONS FOR VARIANCES From Brown (1999) Demski (1967) divided variances into planning and operational variances. Advocated isolating permanent changes and making an after the fact budget. Variances should be analysed as: o Planning (uncontrollable) variances
Arise from the difference between the original planned performance and the revised planned performance These variances provide a check on forecasting skills and also help to provide a revised base for use in forward planning
Some examples of reasons for variances (Drury 2005) Sales volume variance (adverse) Economic recession Increase in selling price Direct materials usage variance (adverse) Careless handling of materials Substandard materials Pilferage Consider interplay of variances how might materials usage/materials price variance, and labour rate/labour efficiency variances affect each other?
STANDARD COSTING A STATUS CHECK (Brown 1999) Survey results, use of variance analysis: Puxty and Lyall survey (1989) - 90%; Drury et al survey (1993) - 76% Current debate (centred on the modern business environment) Rate of change of product type and design is swift Customer demand is for speedy availability of products Product life cycles are shorter There are higher quality standards
This has changed the way businesses operate, as follows: JIT systems allied to flexible manufacturing systems respond to customer demand TQM programmes aim at continuous improvement and effective provision of valueadded activities Greater emphasis on the value chain Changes to ABC and target costing Improved speed and flexibility of information availability e.g. online information in a computer integrated manufacturing environment
CRITICISMS OF STANDARD COSTING (Drury 1999; Brown 1999; McLaney & Atrill 2002) Impact of the changing cost structure standard costing is most suited where there are direct and variable costs Inconsistency with a JIT philosophy (supplier chains, bulk purchases, effect on quality) Motivates behaviour that is inconsistent with TQM philosophy Overemphasises the importance of direct labour Delay in feedback reporting Standards are a static base against which actual events are measured (standards can quickly become out of date; also see problem with TQM above)
Their main objective is control, with conformance to standards and the elimination of any variances this is seen as restrictive and inhibiting (problem for JIT and TQM systems) Can have adverse effects on performance if the link between cost and activity is not well understood, variances may be out of a managers control Areas of responsibility may not have clear lines of demarcation Even with these criticisms, there are still uses for standard costing and variance analysis for a balanced view read Graham, Lyall and Puxty 1992 (in Room 274)
STANDARD COSTING A STATUS CHECK (continued) Area Planning Points in favour of standard costing Standards may be useful as building blocks for budgeting, which has to happen even in a TQM environment Even where automated input of materials occurs, it may still be relevant to analyse costs of changes from plan
Control
Decision making Existing standards may be the starting point for the estimated costs of new products Performance measurement When product mix is stable, performance monitoring may be enhanced by the use of controllable standards
Product pricing
Use of standards can aid the construction of accurate cost estimates for pricing. Target costs may be compared with current standards to highlight the gaps in costing value engineering techniques might then be applied Monitoring standards over time can help to identify situations that are out of control (useful in TQM environments)
AN ALTERNATIVE THE BALANCE SCORECARD AND STRATEGIC MANAGEMENT ACCOUNTING Drury Chapters 15 and 16; Kaplan and Norton (2000) Drury, Chapter 15, deals with alternative ways of improving performance. It also explains some of the terminology used above e.g. target costing, value engineering, business process re-engineering, total quality management, just-in-time, and so on. Drury, Chapter 16, introduces the balanced scorecard, as one way of integrating performance measurement and strategy.
Kaplan and Norton devised and later refined the notion of the balanced scorecard o Aim of the scorecard: to provide a comprehensive framework for translating a companys strategic objectives into a coherent set of performance measures o Each organisation must decide what are its critical performance measures this will vary over time and be linked to the strategy of the organisation o Performance measures must be tied to strategies
Perspective Measures
Kaplan and Norton 1992 Example ECI Corporate Mission: To be number one in delivering value to customers
Financial Goals Survive Succeed Perspective Measures Cash flow Quarterly sales growth and operating income by division Increased market share and ROE Customer Goals New products Perspective Measures % of sales from new products % of sales from proprietary products On-time delivery (defined by customer) Share of key accounts business Ranking by key accounts Number of cooperative engineering efforts Perspective Measures Time to develop next generation Process time to maturity Percent of products that equal 80% of sales New product introduction vs competition
Responsive supply
Prosper
Preferred supplier
Customer partnership
Perspective Measures Manufacturing geometry vs. competition Cycle time, unit cost, yield Silicon efficiency, engineering efficiency Actual introduction schedule vs plan
Innovation and Learning Goals Technology leadership Manufacturing learning Product focus
Time to market