Standard Costs – Overview 1. What are standard Costs. 2. Why do we set standard costs? 3. How do we set the standards? 4. Calculating Variances: DM and DL - Disaggregating variances into price and volume. - Difference between labor and direct materials. - How do we use variances in evaluating performance? 5. Calculating Overhead variances. 6. The incentives created when Standard cost systems are implementedStandard Costs What are standard Costs? Standard costs are the expected costs of manufacturing the product. Standard Direct Labor Costs = Expected wage rate X Expected number of hours Standard Direct Materials cost = Expected cost of raw materials X Expected number of units of raw material. Standard overhead costs = Expected fixed OH + Expected Variable Overhead X Expected number of units to be produced.Standard Costs What is a standard Cost system? A standard cost system is a method of setting cost targets and evaluating performance. Targets or expected costs are set based on a variety of criteria, and actual performance relative to expected targets is measured. Significant differences between expectations and actual results are investigated. Consistent with the themes developed throughout this class, standard cost systems are a means of helping managers with decision making and control.Standard Costs Target Costing 1. The market place determines the selling price of the future product 2. The company determines the profit margin they desire to achieve on this product. 3. The difference between the selling price and the profit margin is the target costStandard Costs Why use a standard cost system? 1. Standards are important for decision making - How we produce our product. - How we price our product. - Contract billing 2. Monitor manufacturing - Large variances may indicative of problems in production. 3. Performance measurement - Deviations between actual and standards are often used as measures of a manager’s performance - Who sets the standard?Standard Costs How do we set the standards? Theoretically the standard should be the expected cost of producing the product. General practices:General practices:1. Prior years performance 2. Expected future performance under normal operating conditions. 3. Optimistic (Motivator)Standard Costs Important considerations in setting standards: 1. Why are senior managers using standards? - Pricing - Performance measurement - Production decisions 2. What happens if managers fail to meet the standards? 3. Standards are supposed to represent the opportunity cost of production.Standard Costs Consider the following information on Beer manufacturing: Expected DM and DL for producing 1000 gallons of beer Standard Quantity Standard Price Total Raw Materials: Wheat 100 lbs $50.00 per pound 5000 Hops 200 lbs $50.00 per pound 10000 Barley 200 lbs $50.00 per pound 10000 Direct Labor 500 hours $20.00 per hour 10000 Total 35,000Standard Costs Actual results associated with the purchase of 1000 gallons of beer Quantity Quantity used Materials and Total Purchased in Production labor price Raw Materials: Wheat 100 lbs 100 lbs $55.00 per pound 5500 Hops 300 lbs 150 lbs $50.00 per pound 7500 Barley 500 lbs 250 lbs $40.00 per pound 10000 Direct Labor 550 hours $22.00 per hour 12100 Total 35100Standard Costs Raw Material Price Variance: Raw Materials Actual price Standard Price Variance Quantity Purchased Total Variance Wheat ? ? ? ? lbs ? Hops ? ? ? ? lbs ? Barley ? ? ? ? lbs ?Standard Costs Raw Material Quantity Variance: Raw Materials Quantity Used Standard Quantity Variance Standard Price Total Variance Wheat ? lbs ? lbs ? ? ? Hops ? lbs ? lbs ? ? ? Barley ? lbs ? lbs ? ? ?Standard Costs What do we do with the raw materials price variance? Who do we hold responsible? What do we do with the raw materials quantity variance? Who do we hold responsible?Standard Costs Direct Labor Wage Variance: Actual price Standard Price Variance Actual Hours Total Variance Direct Labor 22.00 20.00 2.00 550 $1100.00 There is a $1100 unfavorable wage varianceStandard Costs Direct Labor Efficiency Variance: Actual Hours Standard Hours Variance Standard rate Total Variance Direct Labor 550 500 50 20 $1000.00 There is a $1000 unfavorable Efficiency varianceArrow Industries (problem 12-3) See the exercise “Arrow Industries”: Problem 12-3 in Zimmerman, Jerold L. Accounting for Decision Making and Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 624-5.Howard Binding (Problem 12-16) See the exercise “Howard Binding”: Problem 12-16 in Zimmerman, Jerold L. Accounting for Decision Making and Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 630.Standard Costs There are three types of overhead variances that are commonly computed in standard cost systems. Before we describe each of these variances we need to do a brief review on overhead. 1. Overhead consists of both fixed costs and variable costs. 2. Overhead is allocated to the product using an activity base. Thus overhead variances can occur for three reasons 1. the activity base estimate is different than the actual activity base. 2. The amount spent for fixed overhead differs from the standard. 3. The amount spent on variable overhead (the rate per unit) differs from the standard.Standard Costs Overhead spending variance This variance is designed to measure how much overhead was actually incurred compared to the overhead that should have been incurred at the actual volume for the activity base. Spending variance = Actual overhead – budgeted fixed costs – budgeted variable overhead allocation rate * actual activity base.Standard Costs Overhead efficiency variance This variance is a measure of the effect of the difference in the amount of an activity base incurred compared to the expected amount of the activity base. Using additional machine hours or direct labor hours causes additional variable overhead Efficiency variance = Variable overhead allocation rate * ( actual activity base – budgeted activity base)Western Sugar (Problem 13-9) See the exercise “Western Sugar”: Problem 13-9 in Zimmerman, Jerold L. Accounting for Decision Making and Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 660-1.Standard Costs Overhead volume variance The overhead volume variance measures the cost or benefits of using less or more than expected capacity. Volume Variance = Fixed Overhead *(Budgeted volume – actual volume) budgeted volume