The total standard cost to produce one unit of product is shown

23

Standard Costs and Balanced Scorecard

 CHAPTER PREVIEW 

Standards are a fact of life. You met the admission standards for the school you are attending. The vehicle that you drive had to meet certain governmental emissions standards. The hamburgers and salads that you eat in a restaurant have to meet certain health and nutritional standards before they can be sold. As described in our Feature Story, Starbucks has standards for the costs of its materials, labor, and overhead. The reason for standards in these cases is very simple: They help to ensure that overall product quality is high while keeping costs under control.

In this chapter, we continue the study of controlling costs. You will learn how to evaluate performance using standard costs and a balanced scorecard.

80,000 Different Caffeinated Combinations

When Howard Schultz purchased a small Seattle coffee‐roasting business in 1987, he set out to create a new kind of company. He thought the company should sell coffee by the cup in its store, in addition to the bags of roasted beans it already sold. He also saw the store as a place where you could order a beverage, custom‐made to your unique tastes, in an environment that would give you the sense that you had escaped, if only momentarily, from the chaos we call life. Finally, Schultz believed that the company would prosper if employees shared in its success.

In a little more than 20 years, Howard Schultz's company, Starbucks, grew from that one store to over 17,000 locations in 54 countries. That is an incredible rate of growth, and it didn't happen by accident. While Starbucks does everything it can to maximize the customer's experience, behind the scenes it needs to control costs. Consider the almost infinite options of beverage combinations and variations at Starbucks. The company must determine the most efficient way to make each beverage, it must communicate these methods in the form of standards to its employees, and it must then evaluate whether those standards are being met.

Schultz's book, Onward: How Starbucks Fought for Its Life Without Losing Its Soul, describes a painful period in which Starbucks had to close 600 stores and lay off thousands of employees. However, when a prominent shareholder suggested that the company eliminate its employee healthcare plan, as so many other companies had done, Schultz refused. The healthcare plan represented one of the company's most tangible commitments to employee well‐being as well as to corporate social responsibility. Schultz feels strongly that providing health care to the company's employees is an essential part of the standard cost of a cup of Starbucks' coffee.

LEARNING OBJECTIVE 1

Describe standard costs.

Standards are common in business. Those imposed by government agencies are often called regulations. They include the Fair Labor Standards Act, the Equal Employment Opportunity Act, and a multitude of environmental standards. Standards established internally by a company may extend to personnel matters, such as employee absenteeism and ethical codes of conduct, quality control standards for products, and standard costs for goods and services. In managerial accounting, standard costs are predetermined unit costs, which companies use as measures of performance.

We focus on manufacturing operations in this chapter. But you should recognize that standard costs also apply to many types of service businesses as well. For example, a fast‐food restaurant such as McDonald's knows the price it should pay for pickles, beef, buns, and other ingredients. It also knows how much time it should take an employee to flip hamburgers. If the company pays too much for pickles or if employees take too much time to prepare Big Macs, McDonald's notices the deviations and takes corrective action. Not‐for‐profit entities, such as universities, charitable organizations, and governmental agencies, also may use standard costs as measures of performance.

Standard costs offer a number of advantages to an organization, as shown in Illustration 23-1. The organization will realize these advantages only when standard costs are carefully established and prudently used. Using standards solely as a way to place blame can have a negative effect on managers and employees. To minimize this effect, many companies offer wage incentives to those who meet the standards.

ILLUSTRATION 23-1 Advantages of standard costs

DISTINGUISHING BETWEEN STANDARDS AND BUDGETS

Both standards and budgets are predetermined costs, and both contribute to management planning and control. There is a difference, however, in the way the terms are expressed. A standard is a unit amount. A budget is a total amount. Thus, it is customary to state that the standard cost of direct labor for a unit of product is, say, $10. If the company produces 5,000 units of the product, the $50,000 of direct labor is the budgeted labor cost. A standard is the budgeted cost per unit of product. A standard is therefore concerned with each individual cost component that makes up the entire budget.

There are important accounting differences between budgets and standards. Except in the application of manufacturing overhead to jobs and processes, budget data are not journalized in cost accounting systems. In contrast, as we illustrate in the appendix to this chapter, standard costs may be incorporated into cost accounting systems. Also, a company may report its inventories at standard cost in its financial statements, but it would not report inventories at budgeted costs.

SETTING STANDARD COSTS

The setting of standard costs to produce a unit of product is a difficult task. It requires input from all persons who have responsibility for costs and quantities. To determine the standard cost of direct materials, management consults purchasing agents, product managers, quality control engineers, and production supervisors. In setting the standard cost for direct labor, managers obtain pay rate data from the payroll department. Industrial engineers generally determine the labor time requirements. The managerial accountant provides important input for the standard‐setting process by accumulating historical cost data and by knowing how costs respond to changes in activity levels.

To be effective in controlling costs, standard costs need to be current at all times. Thus, standards are under continuous review. They should change whenever managers determine that the existing standard is not a good measure of performance. Circumstances that warrant revision of a standard include changed wage rates resulting from a new union contract, a change in product specifications, or the implementation of a new manufacturing method.

Ideal versus Normal Standards

Companies set standards at one of two levels: ideal or normal. Ideal standards represent optimum levels of performance under perfect operating conditions. Normal standards represent efficient levels of performance that are attainable under expected operating conditions.

Some managers believe ideal standards will stimulate workers to ever‐increasing improvement. However, most managers believe that ideal standards lower the morale of the entire workforce because they are difficult, if not impossible, to meet. Very few companies use ideal standards.

Most companies that use standards set them at a normal level. Properly set, normal standards should be rigorous but attainable. Normal standards allow for rest periods, machine breakdowns, and other “normal” contingencies in the production process. In the remainder of this chapter, we will assume that standard costs are set at a normal level.

 ACCOUNTING ACROSS THE ORGANIZATION 

U.S. Navy

How Do Standards Help a Business?

A number of organizations, including corporations, consultants, and governmental agencies, share information regarding performance standards in an effort to create a standard set of measures for thousands of business processes. The group, referred to as the Open Standards Benchmarking Collaborative, includes IBM, Procter and Gamble, the U.S. Navy, and the World Bank. Companies that are interested in participating can go to the group's website and enter their information.

Source: Becky Partida, “Benchmark Your Manufacturing Performance,” Control Engineering (February 4, 2013).

How will the creation of such standards help a business or organization? (Go to WileyPLUS for this answer and additional questions.)

ETHICS NOTE

When standards are set too high, employees sometimes feel pressure to consider unethical practices to meet these standards.

A Case Study

To establish the standard cost of producing a product, it is necessary to establish standards for each manufacturing cost element—direct materials, direct labor, and manufacturing overhead. The standard for each element is derived from the standard price to be paid and the standard quantity to be used.

To illustrate, we use an extended example. Xonic Beverage Company uses standard costs to measure performance at the production facility of its caffeinated energy drink, Xonic Tonic. Xonic produces one‐gallon containers of concentrated syrup that it sells to coffee and smoothie shops, and other retail outlets. The syrup is mixed with ice water or ice “slush” before serving. The potency of the beverage varies depending on the amount of concentrated syrup used.

DIRECT MATERIALS The direct materials price standard is the cost per unit of direct materials that should be incurred. This standard is based on the purchasing department's best estimate of the cost of raw materials. This cost is frequently based on current purchase prices. The price standard also includes an amount for related costs such as receiving, storing, and handling. The materials price standard per pound of material for Xonic Tonic is as follows.

Item

Price

Purchase price, net of discounts

$ 2.70

Freight

  0.20

Receiving and handling

  0.10

Standard direct materials price per pound

$3.00

ILLUSTRATION 23-2 Setting direct materials price standard

The direct materials quantity standard is the quantity of direct materials that should be used per unit of finished goods. This standard is expressed as a physical measure, such as pounds, barrels, or board feet. In setting the standard, management considers both the quality and quantity of materials required to manufacture the product. The standard includes allowances for unavoidable waste and normal spoilage. The standard quantity per unit for Xonic Tonic is shown in Illustration 23-3.

Item

Quantity (Pounds)

Required materials

3.5

Allowance for waste

0.4

Allowance for spoilage

0.1

Standard direct materials quantity per unit

4.0

ILLUSTRATION 23-3 Setting direct materials quantity standard

The standard direct materials cost per unit is the standard direct materials price times the standard direct materials quantity. For Xonic, the standard direct materials cost per gallon of Xonic Tonic is $12.00 ($3×4 pounds)$12.00 ($3×4 pounds).

DIRECT LABOR The direct labor price standard is the rate per hour that should be incurred for direct labor. This standard is based on current wage rates, adjusted for anticipated changes such as cost of living adjustments (COLAs). The price standard also generally includes employer payroll taxes and fringe benefits, such as paid holidays and vacations. For Xonic, the direct labor price standard is as follows.

Item

Price

Hourly wage rate

$ 12.50

COLA

   0.25

Payroll taxes

   0.75

Fringe benefits

   1.50

Standard direct labor rate per hour

$15.00

ILLUSTRATION 23-4 Setting direct labor price standard

The direct labor quantity standard is the time that should be required to make one unit of the product. This standard is especially critical in labor‐intensive companies. Allowances should be made in this standard for rest periods, cleanup, machine setup, and machine downtime. Illustration 23-5 shows the direct labor quantity standard for Xonic.

Item

Quantity (Hours)

Actual production time

1.5

Rest periods and cleanup

0.2

Setup and downtime

0.3

Standard direct labor hours per unit

2.0

ILLUSTRATION 23-5 Setting direct labor quantity standard

The standard direct labor cost per unit is the standard direct labor rate times the standard direct labor hours. For Xonic, the standard direct labor cost per gallon is $30 ($15×2 hours)$30 ($15×2 hours).

ALTERNATIVE TERMINOLOGY

The direct labor price standard is also called the direct labor rate standard.

ALTERNATIVE TERMINOLOGY

The direct labor quantity standard is also called the direct labor efficiency standard.

MANUFACTURING OVERHEAD For manufacturing overhead, companies use a standard predetermined overhead rate in setting the standard. This overhead rate is determined by dividing budgeted overhead costs by an expected standard activity index. For example, the index may be standard direct labor hours or standard machine hours.

As discussed in Chapter 17, many companies employ activity‐based costing (ABC) to allocate overhead costs. Because ABC uses multiple activity indices to allocate overhead costs, it results in a better correlation between activities and costs incurred than do other methods. As a result, the use of ABC can significantly improve the usefulness of standard costing for management decision‐making.

Xonic uses standard direct labor hours as the activity index. The company expects to produce 13,200 gallons of Xonic Tonic during the year at normal capacity. Normal capacity is the average activity output that a company should experience over the long run. Since it takes two direct labor hours for each gallon, total standard direct labor hours are 26,400 (13,200 gallons×2 hours)26,400 (13,200 gallons×2 hours).

At normal capacity of 26,400 direct labor hours, overhead costs are expected to be $132,000. Of that amount, $79,200 are variable and $52,800 are fixed. Illustration 23-6shows computation of the standard predetermined overhead rates for Xonic.

Budgeted Overhead Costs

Amount

÷

Standard Direct Labor Hours

=

Overhead Rate per Direct Labor Hour

Variable

$ 79,200

26,400

$3.00

Fixed

  52,800

26,400

 2.00

Total

$132,000

26,400

$5.00

ILLUSTRATION 23-6 Computing predetermined overhead rates

The standard manufacturing overhead cost per unit is the predetermined overhead rate times the activity index quantity standard. For Xonic, which uses direct labor hours as its activity index, the standard manufacturing overhead cost per gallon of Xonic Tonic is $10 ($5×2 hours)$10 ($5×2 hours).

TOTAL STANDARD COST PER UNIT After a company has established the standard quantity and price per unit of product, it can determine the total standard cost. The total standard cost per unit is the sum of the standard costs of direct materials, direct labor, and manufacturing overhead. The total standard cost per gallon of Xonic Tonic is $52, as shown on the following standard cost card.

ILLUSTRATION 23-7 Standard cost per gallon of Xonic Tonic

The company prepares a standard cost card for each product. This card provides the basis for determining variances from standards.

DO IT! 1

Standard Costs

Ridette Inc. accumulated the following standard cost data concerning product Cty31.

1. Direct materials per unit: 1.5 pounds at $4 per pound

2. Direct labor per unit: 0.25 hours at $13 per hour.

3. Manufacturing overhead: allocated based on direct labor hours at a predetermined rate of $15.60 per direct labor hour.

Compute the standard cost of one unit of product Cty31.

Action Plan

✓ Know that standard costs are predetermined unit costs.

✓ To establish the standard cost of producing a product, establish the standard for each manufacturing cost element—direct materials, direct labor, and manufacturing overhead.

✓ Compute the standard cost for each element from the standard price to be paid and the standard quantity to be used.

SOLUTION

Manufacturing Cost Element

Standard Quantity

×

Standard Price

=

Standard Cost

Direct materials

1.5 pounds

$ 4.00

$ 6.00

Direct labor

0.25 hours

$13.00

  3.25

Manufacturing overhead

0.25 hours

$15.60

  3.90

Total

$13.15

Related exercise material: BE23-2, BE23-3, E23-1, E23-2, E23-3, and DO IT! 23-1.

LEARNING OBJECTIVE 2

Determine direct materials variances.

ANALYZING AND REPORTING VARIANCES

One of the major management uses of standard costs is to identify variances from standards. Variances are the differences between total actual costs and total standard costs.

To illustrate, assume that in producing 1,000 gallons of Xonic Tonic in the month of June, Xonic incurred the following costs.

Direct materials

$13,020

Direct labor

31,080

Variable overhead

6,500

Fixed overhead

  4,400

Total actual costs

$55,000

ILLUSTRATION 23-8 Actual production costs

Companies determine total standard costs by multiplying the units produced by the standard cost per unit. The total standard cost of Xonic Tonic is $52,000 (1,000 gallons×$52)$52,000 (1,000 gallons×$52). Thus, the total variance is $3,000, as shown below.

Actual costs

$55,000

Less: Standard costs

 52,000

Total variance

$ 3,000

ILLUSTRATION 23-9 Computation of total variance

Note that the variance is expressed in total dollars, not on a per unit basis.

When actual costs exceed standard costs, the variance is unfavorable. The $3,000 variance in June for Xonic Tonic is unfavorable. An unfavorable variance has a negative connotation. It suggests that the company paid too much for one or more of the manufacturing cost elements or that it used the elements inefficiently.

If actual costs are less than standard costs, the variance is favorable. A favorable variance has a positive connotation. It suggests efficiencies in incurring manufacturing costs and in using direct materials, direct labor, and manufacturing overhead.

However, be careful: A favorable variance could be obtained by using inferior materials. In printing wedding invitations, for example, a favorable variance could result from using an inferior grade of paper. Or, a favorable variance might be achieved in installing tires on an automobile assembly line by tightening only half of the lug bolts. A variance is not favorable if the company has sacrificed quality control standards.

To interpret a variance, you must analyze its components. A variance can result from differences related to the cost of materials, labor, or overhead. Illustration 23-10 shows that the total variance is the sum of the materials, labor, and overhead variances.

Materials Variance+Labor Variance+Overhead Variance=Total VarianceMaterials Variance+Labor Variance+Overhead Variance=Total Variance ILLUSTRATION 23-10 Components of total variance

In the following discussion, you will see that the materials variance and the labor variance are the sum of variances resulting from price differences and quantity differences. Illustration 23-11 shows a format for computing the price and quantity variances.

ILLUSTRATION 23-11 Breakdown of materials or labor variance into price and quantity variances

Note that the left side of the matrix is actual cost (actual quantity times actual price). The right hand is standard cost (standard quantity times standard price). The only additional element you need in order to compute the price and quantity variances is the middle element, the actual quantity at the standard price.

ALTERNATIVE TERMINOLOGY

In business, the term variance is also used to indicate differences between total budgeted and total actual costs.

DIRECT MATERIALS VARIANCES

Part of Xonic's total variance of $3,000 is due to a materials variance. In completing the order for 1,000 gallons of Xonic Tonic, the company used 4,200 pounds of direct materials. The direct materials were purchased at a price of $3.10 per unit. From Illustration 23-3, we know that Xonic's standards require it to use 4 pounds of materials per gallon produced, so it should have only used 4,000 (4×1,000)4,000 (4×1,000) pounds of direct materials to produce 1,000 gallons. Illustration 23-2 shows that the standard cost of each pound of direct materials is $3 instead of the $3.10 actually paid. Illustration 23-12 shows that the total materials variance is computed as the difference between the amount paid (actual quantity times actual price) and the amount that should have been paid based on standards (standard quantity times standard price of materials).

Actual QuantityStandard QuantityTotal Materials×Actual Price−×Standard Price=Variance(AQ)×(AP)(SQ)×(SP)(TMV)(4,200×$3.10)−(4,000×$3.00)=$1,020 UActual QuantityStandard QuantityTotal Materials×Actual Price−×Standard Price=Variance(AQ)×(AP)(SQ)×(SP)(TMV)(4,200×$3.10)−(4,000×$3.00)=$1,020 U ILLUSTRATION 23-12 Formula for total materials variance

Thus, for Xonic, the total materials variance is $1,020 ($13,020−$12,000)$1,020 ($13,020−$12,000) unfavorable.

The total materials variance could be caused by differences in the price paid for the materials or by differences in the amount of materials used. Illustration 23-13 shows that the total materials variance is the sum of the materials price variance and the materials quantity variance.

Materials Price Variance+Materials Quantity Variance=Total Materials VarianceMaterials Price Variance+Materials Quantity Variance=Total Materials Variance ILLUSTRATION 23-13 Components of total materials variance

The materials price variance results from a difference between the actual price and the standard price. Illustration 23-14 shows that the materials price variance is computed as the difference between the actual amount paid (actual quantity of materials times actual price) and the standard amount that should have been paid for the materials used (actual quantity of materials times standard price).1

Actual QuantityActual QuantityMaterials Price×Actual Price−×Standard Price=Variance(AQ)×(AP)(AQ)×(SP)(MPV)(4,200×$3.10)−(4,200×$3.00)=$420 UActual QuantityActual QuantityMaterials Price×Actual Price−×Standard Price=Variance(AQ)×(AP)(AQ)×(SP)(MPV)(4,200×$3.10)−(4,200×$3.00)=$420 U ILLUSTRATION 23-14 Formula for materials price variance

For Xonic, the materials price variance is $420 ($13,020−$12,600)$420 ($13,020−$12,600) unfavorable.

The price variance can also be computed by multiplying the actual quantity purchased by the difference between the actual and standard price per unit. The computation in this case is 4,200×($3.10−$3.00)=$420 U4,200×($3.10−$3.00)=$420 U.

As seen in Illustration 23-13, the other component of the materials variance is the quantity variance. The quantity variance results from differences between the amount of material actually used and the amount that should have been used. As shown in Illustration 23-15, the materials quantity variance is computed as the difference between the standard cost of the actual quantity (actual quantity times standard price) and the standard cost of the amount that should have been used (standard quantity times standard price for materials).

Actual QuantityStandard QuantityMaterials Quantity×Standard Price−×Standard Price=Variance(AQ)×(SP)(SQ)×(SP)(MQV)(4,200×$3.00)−(4,000×$3.00)=$600 UActual QuantityStandard QuantityMaterials Quantity×Standard Price−×Standard Price=Variance(AQ)×(SP)(SQ)×(SP)(MQV)(4,200×$3.00)−(4,000×$3.00)=$600 U ILLUSTRATION 23-15 Formula for materials quantity variance

Thus, for Xonic, the materials quantity variance is $600 ($12,600−$12,000)$600 ($12,600−$12,000) unfavorable.

The quantity variance can also be computed by applying the standard price to the difference between actual and standard quantities used. The computation in this example is $3.00×(4,200−4,000)=$600 U$3.00×(4,200−4,000)=$600 U.

The total materials variance of $1,020 U, therefore, consists of the following.

Materials price variance

$  420 U

Materials quantity variance

   600 U

Total materials variance

$1,020 U

ILLUSTRATION 23-16 Summary of materials variances

Companies sometimes use a matrix to analyze a variance. When the matrix is used, a company computes the amounts using the formulas for each cost element first and then computes the variances. Illustration 23-17 shows the completed matrix for the direct materials variance for Xonic. The matrix provides a convenient structure for determining each variance.

ILLUSTRATION 23-17 Matrix for direct materials variances

DECISION TOOLS

The materials price and materials quantity variances help managers determine if they have met their price and quantity objectives regarding materials.

▼ HELPFUL HINT

The alternative formula is:

AQ×AP−SP=MPVAQ×AP−SP=MPV

▼ HELPFUL HINT

The alternative formula is:

SP×AQ−SQ=MQVSP×AQ−SQ=MQV

Causes of Materials Variances

What are the causes of a variance? The causes may relate to both internal and external factors. The investigation of a materials price variance usually begins in the purchasing department. Many factors affect the price paid for raw materials. These include availability of quantity and cash discounts, the quality of the materials requested, and the delivery method used. To the extent that these factors are considered in setting the price standard, the purchasing department is responsible for any variances.

However, a variance may be beyond the control of the purchasing department. Sometimes, for example, prices may rise faster than expected. Moreover, actions by groups over which the company has no control, such as the OPEC nations' oil price increases, may cause an unfavorable variance. For example, during a recent year, Kraft Foods and Kellogg Company both experienced unfavorable materials price variances when the cost of dairy and wheat products jumped unexpectedly. There are also times when a production department may be responsible for the price variance. This may occur when a rush order forces the company to pay a higher price for the materials.

The starting point for determining the cause(s) of a significant materials quantity variance is in the production department. If the variances are due to inexperienced workers, faulty machinery, or carelessness, the production department is responsible. However, if the materials obtained by the purchasing department were of inferior quality, then the purchasing department is responsible.

DO IT! 2

Direct Materials Variances

The standard cost of Wonder Walkers includes two units of direct materials at $8.00 per unit. During July, the company buys 22,000 units of direct materials at $7.50 and uses those materials to produce 10,000 Wonder Walkers. Compute the total, price, and quantity variances for materials.

Action Plan

Use the formulas for computing each of the materials variances:

✓ Total materials variance=(AQ×AP)−(SQ×SP)Total materials variance=(AQ×AP)−(SQ×SP)

✓ Materials price variance=(AQ×AP)−(AQ×SP)Materials price variance=(AQ×AP)−(AQ×SP)

✓ Materials quantity variance=(AQ×SP)−(SQ×SP)Materials quantity variance=(AQ×SP)−(SQ×SP)

SOLUTION

Standard quantity=10,000×2Standard quantity=10,000×2

Substituting amounts into the formulas, the variances are:

Total materials variance=(22,000×$7.50)−(20,000×$8.00)=$5,000 unfavorableTotal materials variance=(22,000×$7.50)−(20,000×$8.00)=$5,000 unfavorable

Materials price variance=(22,000×$7.50)−(22,000×$8.00)=$11,000 favorableMaterials price variance=(22,000×$7.50)−(22,000×$8.00)=$11,000 favorable

Materials quantity variance=(22,000×$8.00)−(20,000×$8.00)=$16,000 unfavorableMaterials quantity variance=(22,000×$8.00)−(20,000×$8.00)=$16,000 unfavorable

Related exercise material: BE23-4, E23-5, and DO IT! 23-2.

LEARNING OBJECTIVE 3

Determine direct labor and total manufacturing overhead variances.

DIRECT LABOR VAR