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The largest internal user buys the product in a degree of finish less than for that sold on the outside, which makes finding comparable market prices impossible. One of the chemical companies in my study provides a perfect illustration of a collaborative organization. One of its major businesses is the largest producer in its industry. All three businesses are critical to the success accounting of the company. These businesses are capital intensive and their managers accept internal sourcing without question. Transfer prices are market based, less a small discount to reflect the fact that sales effort and other expenses are not required. The sense of fairness in collaborative organizations is based on a rational trust the unit managers have in top management.
The rational component signifies the impartial spectator standards of fairness appropriate for competitive organizations. The trust component signifies the shared-fate standards of fairness appropriate for cooperative organizations. The management processes shaping corporate-business unit relationships are iterative in nature.
- Standard prices of direct material are controlled by the purchasing department and price variances will therefore reflect the efficiency of the purchasing department.
- Predetermination of standard costs in full detail under each element of cost, i.e., Material, Labour, overheads.
- In the mid-1960s, as part of a reorganization to a matrix structure, a task force recommended a market-based system to allocate variances.
- Mixed-mode bargaining processes between business units are a consequence of their simultaneously competitive and cooperative relationships.
- The interpersonal and the substantive issues can get confused.
The budgeted overhead is calculated by adding budgeted variable costs for the actual number of units to the budgeted fixed costs . The relationships in the analysis above are also illustrated in the graphic approach presented in Figure 10-2. The total variance is the vertical difference between points A’ and D. Since the actual costs, represented by point A’ do not fall on the flexible budget line, the actual price must be different from the standard price. The vertical difference between points A’ and C represents the material price variance based on quantity used. Points A and B are no longer relevant because they are based on the quantity purchased.
Budgetary Performance Evaluation o Western Rider’s standard costs per unit for XL jeans are shown in Exhibit 1. Therefore, a variance based on quantity purchased is basically an earlier report than a variance based on quantity actually used. This is quite beneficial from the viewpoint of performance measurement and corrective action. An early report will help the management in measuring the performance so that poor performance can be corrected or good performance can be expanded at an early date. Management has little control over price variances, especially when they result from rising prices.
High Hourly Rates
The choice of the standard depends upon two factors, viz., its effectiveness for cost control, and as a measure of productive efficiency within or outside the accounting system as statistical data. The existing costing system should be reviewed with special reference to the existing records and forms. For clear definitions of standard costs, the existing costs in general and the methods of allocation and apportionment of overheads in particular should be studied. It should be noted in this connection that standard costing is not a separate system of accounting but only a technique used with the intention of controlling the costs.
Although represents the credit to materials control, does not represent the debit to WIP. This is because the entry to WIP involves both price and quantity variances. Although the mechanics of standard costing are adequately illustrated with T-accounts, journal entries and equations, the concepts are somewhat more illusive. Conceptually the variances represent an attempt to evaluate materials costs by isolating the effects of price and quantity differences. The flexible budget diagram in Exhibit 10-5 provides a more revealing way to emphasize these performance measurement concepts. The following pages include illustrations of how each type of manufacturing cost is recorded and analyzed using a complete standard cost method. Several types of illustrations are presented to help you see the concepts and techniques from different perspectives.
The term ‘standard cost’ has been defined as a predetermined cost which is calculated from the management’s standards of efficient operation and the relevant necessary expenditure. This is a schedule that is used to calculate the cost of producing the company’s products for a set period of time. Let’s say that XYZ Company manufactures automobiles and it costs the company $250 to make one steering wheel. In order to run its business, the company incurs $550,000 in rental fees for its factory space. If revised budgeted quantity is more than the budgeted quantity; the variance is favourable; if revised budgeted quantity is less, the variance will be unfavourable. In a period, many class B workers were absent and it was necessary to substitute class B workers. Since the class A workers were less experienced with the job, more labour hours were used.
The yield variance is the result of obtaining a yield different from the one expected on the basis of input. The engineering department is normally responsible for setting quantity standards because it bookkeeping is generally responsible for designing production processes for making a product. Many manufacturing companies have separated departments that are assigned the responsibility for setting standards.
The management gives attention to the variances and takes corrective steps. The costing reports, based on standard cost, reveal the overall result of the manufacturing side. ‘Normal’ standard represents the level of performance attainable under normal operating conditions, i.e., normal efficiency, normal sales, normal production volume, etc. It focuses on the practical attainable efficiency, after taking into consideration normal imperfections. An ‘ideal’ standard is one which can be attained under the most favourable conditions. It represents the level of performance attainable with the ‘best’ or ideal set-up, i.e., best quality materials at favourable prices, highly skilled labour and best equipment. This standard focuses on maximum efficiency in the utilisation of resources, i.e., maximum output with minimum cost.
The production volume variance measures the variance caused by the difference between the denominator output level, i.e., capacity used to calculate the overhead rates, and the output level actually achieved. If unit data are available, it may also be calculated in the following manner.
Exhibit 10-2 includes eight variance accounts along with the usual generic accounts used in normal historical costing. These include the direct materials price variance and the direct materials quantity variance. Since a cost always involves a price and a quantity, the idea is to isolate the effects of differences between actual and standard prices from the effects of differences between actual and standard quantities. The same idea is used to analyze direct labor costs, although the DL variances are frequently referred to as the DL rate variance and DL efficiency variance. However, there are a variety of ways to analyze factory overhead costs.
Labor Usage
Clearly, this is favorable because the actual quantity used was lower than the expected quantity. The term overhead includes indirect material, indirect labour and indirect expenses. Overhead variances may relate to factory, office or selling and distribution overheads. For the purposes of variance analysis, overheads are divided broadly into two categories viz., fixed and variable. Just as material yield variance is calculated similarly labour yield variance can also be known.
In this section and the following section on fixed overhead, we will consider the equation approach first, followed by flexible budget diagrams and graphic illustrations. The T-account approach and the journal entries for overhead costs are presented after all four of the overhead variances have been discussed individually.
Direct Materials Usage Variance
To take an example, in a day, a man sets his task of completing 100 units in 10 hours, whereas he could work only for 9 hours, and completed 95 units. It will cause an adverse volume variance at the standard rate per unit of overhead cost. As regards the man’s capacity is concerned it has been reduced by 1 hour; hence an adverse capacity variance of 10 units; however as for his efficiency, it has increased. It is the difference between the standard cost of production achieved and the actual total quantity of materials used at standard ratio/composition at standard price.
The vertical difference between points A and B represents the variable overhead spending variance. The vertical difference between points B and D represents the variable overhead efficiency variance. Since direct labor hours used and purchased are equal, A’ and C are not needed in the analysis.
If actual hours worked are less than the standard hours, the variance is favourable and when actual hours are more than the standard hours, the variance is unfavourable. (No. of actual working days – No. of budgeted working days) x Std. Calendar variance can be computed based on hours or output. The analysis of factory overhead variances is more complex than variance analysis for direct materials and direct labour. There is no standardisation of the terms or methods used for calculating overhead variances. For this reason, it is necessary to be familiar with the different approaches which can be applied in overhead variances.
Standards are useful in detailed planning, cost control, performance measurement, and pricing decision. This unit examines how standards are set for material, labour, and manufacturing overheads. It illustrated the calculation of material, labour and manufacturing overheads variances and their analysis and interpretation. The first entry records the actual factory overhead costs of $364,000 the standard price and quantity of direct materials are separated because: and shows a credit to miscellaneous accounts. The second entry charges the standard overhead costs of $320,000 to the work in process account. This leaves a debit balance in the factory overhead account of $44,000 that represents an unfavorable total factory overhead variance. The third entry closes the factory overhead account by distributing the variances to the four variance accounts.
Arguing over transfer prices seems a more legitimate way of conducting this dispute than name-calling. The interpersonal and the substantive issues can get confused. Even if the company has a transfer pricing policy appropriate for its strategy, five common problems can lead to conflict. Here, too, management processes are far more important than any attempt to find technical solutions. Define measures of diversification and vertical integration appropriate to the company. Place inter-business-unit relationships on the MAP according to strategies of business units and strategy for their relationship. The CEO has made special efforts to let managers know that he recognizes their individual contributions to the company.
They merely represent more or less applied fixed overhead costs than budgeted fixed overhead costs. Both variances occur because of the attempt to match cost against benefits and obtain the advantages of using a predetermined overhead rate, e.g., normalizing unit overhead cost and more timely costing and pricing. If some other activity measure were used to apply overhead, (e.g., machine hours) then the flexible budget would be based on the actual quantity of that measurement, rather than actual direct labor hours . Standard costs are used to establish the flexible budget for direct materials. The flexible budget is compared to actual costs, and the difference is shown in the form of two variances.
Direct Materials Quantity
The four overhead variances that appear in Exhibit 10-2 provides one possibility. These include the variable overhead spending variance, VO efficiency variance, the fixed overhead spending variance and the production volume variance. As we shall see later in this chapter, the overhead variances are not price and quantity variances and are much more difficult to interpret in any meaningful way. All of the overhead variances can be calculated in a combined approach that emphasizes the flexible budgets involved. A four variance approach appears on the right-hand side of the exhibit and a two variance approach appears on the left side. The difference between items 1 and 4 is the total unfavorable variance in factory overhead costs of $44,000. The difference between actual total overhead costs and a flexible budget based on actual direct labor hours is the total spending variance of $1,000 U.
To summarize the ideas in this section, the standard cost methodology recognizes that prices and quantities drive costs, but the typical analysis does not reveal the causes of the variances beyond that level. Variance analysis does not identify why actual prices and quantities are different from standard, only that they are different. From a practical standpoint, the benefits of developing routine analysis below the price and quantity level (see Exhibit 10-9) would not likely exceed the additional costs. However, when variances are outside an acceptable range established by management, they should be investigated and corrective action taken if it appears to be needed. When implementing this idea, management should take care not to blame workers for variations caused by the system. Corrective action refers to adjustments to eliminate special causes. Reduction in system variation requires an improvement in the system as explained in Chapter 3.
Choice “c” Is Incorrect A Change In The Number Of Units Sold Is Compensated For By The Flex In The Flexible Budget
A way to promote cooperation, rather than competitive behavior, is to use variance analysis at the plant level to monitor overall operations, but not as a way to micro manage at the departmental level. At the department level, there are more important measurements that are process oriented rather than financial results oriented.
Therefore, cost side of the sales variance is assumed constant under the margin method. The first approach i.e., sales variance based on turnover, accounts for difference in actual sales and budgeted sales. The sales variances using margin approach accounts for difference in actual profit and budgeted profit. In Accounting Periods and Methods the margin method, it is assumed that cost of production is constant, i.e., no difference is assumed between actual cost of production and standard cost of production. This variance indicates the difference between the actual fixed overhead cost and standard fixed overhead cost allowed for the actual output.
Standard costing can be used by any industry irrespective of whether it has job costing, process costing or any other method of costing. However, it can be used more effectively in industries which have standardised repetitive nature of operations i.e. process industry. Taking appropriate action on the basis of the nature of variances, i.e. controllable and non-controllable. Presentation of variances to management for taking appropriate action and remedial measures. Hence, a standard figure is one against which one can measure an actual figure to ascertain how much actual figures differ from standard. Assigning cost to materials, work-in-process and finished goods inventories.