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 felt that the store shouldn't just sell coffee but also a pleasant atmosphere and experience. Schultz 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 health-care plan, as so many other companies had done, Schultz refused. The health-care 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.
Preview of Chapter 25
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.
The content and organization of Chapter 25 are as follows.
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 will focus on manufacturing operations in this chapter. But you should also 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.
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 Appendix 25A, 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.
Standard costs offer a number of advantages to an organization, as shown in Illustration 25-1.
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.
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.
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.
Ethics Note
When standards are set too high, employees sometimes feel pressure to consider unethical practices to meet these standards.
ACCOUNTING ACROSS THE ORGANIZATION
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: William M. Bulkeley, “Business, Agencies to Standardize Their Benchmarks,” Wall Street Journal (May 19, 2004).
How will the creation of such standards help a business or organization? (See page 1225.)
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.
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:
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 as follows.
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).
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.
Alternative Terminology
The direct labor price standard is also called the direct labor rate 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. For Xonic, the direct labor quantity standard is as follows.
Alternative Terminology
The direct labor quantity standard is also called the direct labor efficiency 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).
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 21, 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).
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 25-6 shows computation of the standard predetermined overhead rates for Xonic.
The standard manufacturing overhead rate 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 rate per gallon of Xonic Tonic is $10 ($5 × 2 hours).
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.
The company prepares a standard cost card for each product. This card provides the basis for determining variances from standards.
MANAGEMENT INSIGHT
How Can We Make Susan's Chili Profitable?
Susan's Chili Factory manufactures and sells chili. The cost of manufacturing Susan's chili consists of the costs of raw materials, labor to convert the basic ingredients to chili, and overhead. Managers need to develop three standards for materials: (1) What should be the formula (mix) of ingredients for one gallon of chili? (2) What should be the normal wastage (or shrinkage) for the individual ingredients? (3) What should be the standard cost for the individual ingredients that go into the chili?
Susan's Chili Factory also illustrates how managers can use standard costs in controlling costs. Suppose that summer droughts have reduced crop yields. As a result, prices have doubled for beans, onions, and peppers. In this case, actual costs will be significantly higher than standard costs, which will cause management to evaluate the situation. Similarly, assume that poor maintenance caused the onion-dicing blades to become dull. As a result, usage of onions to make a gallon of chili tripled. Because this deviation is quickly highlighted through standard costs, managers can take corrective action promptly.
Source: Adapted from David R. Beran, “Cost Reduction Through Control Reporting,” Management Accounting (April 1982), pp. 29–33.
How might management use this raw materials cost information? (See page 1225.)
DO IT!
Standard Costs
Ridette Inc. accumulated the following standard cost data concerning product Cty31.
Direct materials per unit: 1.5 pounds at $4 per pound.
Direct labor per unit: 0.25 hours at $13 per hour.
Manufacturing overhead: predetermined rate is 120% of direct labor cost.
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
Related exercise material: BE25-2, BE25-3, E25-1, E25-2, E25-3, and DO IT! 25-1.
State the formulas for determining direct materials and direct labor 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.
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). Thus, the total variance is $3,000, as shown below.
Alternative Terminology
In business, the term variance is also used to indicate differences between total budgeted and total actual costs.
Note that the variance is expressed in total dollars, and 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 25-10 shows that the total variance is the sum of the materials, labor, and overhead variances.
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 25-11 shows a format for computing the 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.
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 25-3, 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) pounds of direct materials to produce 1,000 gallons. Illustration 25-2 shows that the standard cost of each pound of direct materials is $3 instead of the $3.10 actually paid. Illustration 25-12 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).
Thus, for Xonic, the total materials variance is $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 25-13 (page 1186) shows that the total materials variance is the sum of the materials price variance and the materials quantity variance.
The materials price variance results from a difference between the actual price and the standard price. Illustration 25-14 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
Helpful Hint The alternative formula is:
For Xonic, the materials price variance is $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 U.
As seen in Illustration 25-13, 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 25-15, 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).
Thus, for Xonic, the materials quantity variance is $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.
The total materials variance of $1,020 U, therefore, consists of the following.
Helpful Hint The alternative formula is:
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 25-17 shows the completed matrix for the direct materials variance for Xonic. The matrix provides a convenient structure for determining each variance.
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.
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)
Materials price variance = (AQ × AP) − (AQ × SP)
Materials quantity variance = (AQ × SP) − (SQ × SP)
Solution
Standard 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 unfavorable
Materials 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 unfavorable
Related exercise material: BE25-4, E25-5, and DO IT! 25-2.
The process of determining direct labor variances is the same as for determining the direct materials variances. In completing the Xonic Tonic order, the company incurred 2,100 direct labor hours at an average hourly rate of $14.80. The standard hours allowed for the units produced were 2,000 hours (1,000 gallons × 2 hours). The standard labor rate was $15 per hour.
The total labor variance is the difference between the amount actually paid for labor versus the amount that should have been paid. Illustration 25-18 shows that the total labor variance is computed as the difference between the amount actually paid for labor (actual hours times actual rate) and the amount that should have been paid (standard hours times standard rate for labor).
The total labor variance is $1,080 ($31,080 − $30,000) unfavorable.
The total labor variance is caused by differences in the labor rate or difference in labor hours. Illustration 25-19 shows that the total labor variance is the sum of the labor price variance and the labor quantity variance.
The labor price variance results from the difference between the rate paid to workers versus the rate that was supposed to be paid. Illustration 25-20 shows that the labor price variance is computed as the difference between the actual amount paid (actual hours times actual rate) and the amount that should have been paid for the number of hours worked (actual hours times standard rate for labor).
For Xonic, the labor price variance is $420 ($31,080 − $31,500) favorable.
The labor price variance can also be computed by multiplying actual hours worked by the difference between the actual pay rate and the standard pay rate. The computation in this example is 2,100 × ($15.00 − $14.80) = $420 F.
The other component of the total labor variance is the labor quantity variance. The labor quantity variance results from the difference between the actual number of labor hours and the number of hours that should have been worked for the quantity produced. Illustration 25-21 shows that the labor quantity variance is computed as the difference between the amount that should have been paid for the hours worked (actual hours times standard rate) and the amount that should have been paid for the amount of hours that should have been worked (standard hours times standard rate for labor).
Helpful Hint The alternative formula is:
Thus, for Xonic, the labor quantity variance is $1,500 ($31,500 − $30,000) unfavorable.
The same result can be obtained by multiplying the standard rate by the difference between actual hours worked and standard hours allowed. In this case, the computation is $15.00 × (2,100 − 2,000) = $1,500 U.
The total direct labor variance of $1,080 U, therefore, consists of:
Helpful Hint The alternative formula is:
These results can also be obtained from the matrix in Illustration 25-23 (page 1190).
Labor price variances usually result from two factors: (1) paying workers different wages than expected, and (2) misallocation of workers. In companies where pay rates are determined by union contracts, labor price variances should be infrequent. When workers are not unionized, there is a much higher likelihood of such variances. The responsibility for these variances rests with the manager who authorized the wage change.
Misallocation of the workforce refers to using skilled workers in place of unskilled workers and vice versa. The use of an inexperienced worker instead of an experienced one will result in a favorable price variance because of the lower pay rate of the unskilled worker. An unfavorable price variance would result if a skilled worker were substituted for an inexperienced one. The production department generally is responsible for labor price variances resulting from misallocation of the workforce.
Labor quantity variances relate to the efficiency of workers. The cause of a quantity variance generally can be traced to the production department. The causes of an unfavorable variance may be poor training, worker fatigue, faulty machinery, or carelessness. These causes are the responsibility of the production department. However, if the excess time is due to inferior materials, the responsibility falls outside the production department.
The total overhead variance is the difference between the actual overhead costs and overhead costs applied based on standard hours allowed for the amount of goods produced. As indicated in Illustration 25-8 (page 1184), Xonic incurred overhead costs of $10,900 to produce 1,000 gallons of Xonic Tonic in June. The computation of the actual overhead is comprised of a variable and a fixed component. Illustration 25-24 shows this computation.
To find the total overhead variance in a standard costing system, we determine the overhead costs applied based on standard hours allowed. Standard hours allowed are the hours that should have been worked for the units produced. Overhead costs for Xonic Tonic are applied based on direct labor hours. Because it takes two hours of direct labor to produce one gallon of Xonic Tonic, for the 1,000-gallon Xonic Tonic order, the standard hours allowed are 2,000 hours (1,000 gallons × 2 hours). We then apply the predetermined overhead rate to the 2,000 standard hours allowed.
Recall from Illustration 25-6 (page 1182) that the amount of budgeted overhead costs at normal capacity of $132,000 was divided by normal capacity of 26,400 direct labor hours, to arrive at a predetermined overhead rate of $5 ($132,000 ÷ 26,400). The predetermined rate of $5 is then multiplied by the 2,000 standard hours allowed, to determine the overhead costs applied.
Illustration 25-25 shows the formula for the total overhead variance and the calculation for Xonic for the month of June.
Thus, for Xonic, the total overhead variance is $900 unfavorable.
The overhead variance is generally analyzed through a price and a quantity variance. (These computations are discussed in more detail in advanced courses.) The name usually given to the price variance is the overhead controllable variance; the quantity variance is referred to as the overhead volume variance. Appendix 25B discusses how the total overhead variance can be broken down into these two variances.
One reason for an overhead variance relates to over- or underspending on overhead items. For example, overhead may include indirect labor for which a company paid wages higher than the standard labor price allowed. Or, the price of electricity to run the company's machines increased, and the company did not anticipate this additional cost. Companies should investigate any spending variances, to determine whether they will continue in the future. Generally, the responsibility for these variances rests with the production department.
The overhead variance can also result from the inefficient use of overhead. For example, because of poor maintenance, a number of the manufacturing machines are experiencing breakdowns on a consistent basis, leading to reduced production. Or, the flow of materials through the production process is impeded because of a lack of skilled labor to perform the necessary production tasks, due to a lack of planning. In both of these cases, the production department is responsible for the cause of these variances. On the other hand, overhead can also be underutilized because of a lack of sales orders. When the cause is a lack of sales orders, the responsibility rests outside the production department. For example, at one point Chrysler experienced a very significant unfavorable overhead variance because plant capacity was maintained at excessively high levels, due to overly optimistic sales forecasts.
PEOPLE, PLANET, AND PROFIT INSIGHT
What's Brewing at Starbucks?
It is one thing for a company to say it is committed to corporate social responsibility. It is another thing for the company to actually spell out measurable goals. Recently, Starbucks published its 10th annual Global Responsibility Report in which it describes its goals, achievements, and even its shortcomings related to corporate social responsibility. For example, the company achieved its goal of getting more than 50% of its electricity from renewable sources. It then set its sights higher by setting a goal of 100% within five years. The company also has numerous goals related to purchasing coffee from sources that are certified as responsibly grown and ethically traded; providing funds for loans to coffee farmers; and partnerships with Conservation International to provide training to farmers on ecologically friendly growing. Further, the company reduced water consumption by more than 20% in a two-year period. Finally, it made a significant investment in programs to increase recycling of paper and plastic at its stores.
The report also candidly explains that the company did not meet its goal to cut energy consumption by 25%. It also fell far short of its goal of getting customers to reuse their cups. In those instances where it didn't achieve its goals, Starbucks set new goals and described steps it would take to achieve them. You can view the company's Global Responsibility Report at www.starbucks.com/2010report.
Source: “Starbucks Launches 10th Global Responsibility Report,” Business Wire (April 18, 2011).
What implications does Starbucks’ commitment to corporate social responsibility have for the standard cost of a cup of coffee? (See page 1225.)
DO IT!
Labor and Manufacturing Overhead Variances
The standard cost of Product YY includes 3 hours of direct labor at $12.00 per hour. The predetermined overhead rate is $20.00 per direct labor hour. During July, the company incurred 3,500 hours of direct labor at an average rate of $12.40 per hour and $71,300 of manufacturing overhead costs. It produced 1,200 units.
(a) Compute the total, price, and quantity variances for labor. (b) Compute the total overhead variance.
Action Plan
Use the formulas for computing each of the variances:
Total labor variance = (AH × AR) − (SH × SR) Labor price variance = (AH × AR) − (AH × SR) Labor quantity variance = (AH × SR) − (SH × SR) Total overhead variance = Actual overhead − Overhead applied*
Solution
Substituting amounts into the formulas, the variances are:
Total labor variance = (3,500 × $12.40) − (3,600 × $12.00) = $200 unfavorable
Labor price variance = (3,500 × $12.40) − (3,500 × $12.00) = $1,400 unfavorable
Labor quantity variance = (3,500 × $12.00) − (3,600 × $12.00) = $1,200 favorable
Total overhead variance = $71,300 − $72,000* = $700 favorable
Related exercise material: BE25-5, BE25-6, E25-4, E25-6, E25-7, E25-8, E25-10, and DO IT! 25-3.
All variances should be reported to appropriate levels of management as soon as possible. The sooner managers are informed, the sooner they can evaluate problems and take corrective action.
The form, content, and frequency of variance reports vary considerably among companies. One approach is to prepare a weekly report for each department that has primary responsibility for cost control. Under this approach, materials price variances are reported to the purchasing department, and all other variances are reported to the production department that did the work. The following report for Xonic, with the materials for the Xonic Tonic order listed first, illustrates this approach.
The explanation column is completed after consultation with the purchasing department manager.
Variance reports facilitate the principle of “management by exception” explained in Chapter 24. For example, the vice president of purchasing can use the report shown above to evaluate the effectiveness of the purchasing department manager. Or, the vice president of production can use production department variance reports to determine how well each production manager is controlling costs. In using variance reports, top management normally looks for significant variances. These may be judged on the basis of some quantitative measure, such as more than 10% of the standard or more than $1,000.
In income statements prepared for management under a standard cost accounting system, cost of goods sold is stated at standard cost and the variances are disclosed separately. Unfavorable variances increase cost of goods sold, while favorable variances decrease cost of goods sold. Illustration 25-27 (page 1194) shows the presentation of variances in an income statement. This income statement is based on the production and sale of 1,000 units of Xonic Tonic at $70 per unit. It also assumes selling and administrative costs of $3,000. Observe that each variance is shown, as well as the total net variance. In this example, variations from standard costs reduced net income by $3,000.
Standard costs may be used in financial statements prepared for stockholders and other external users. The costing of inventories at standard costs is in accordance with generally accepted accounting principles when there are no significant differences between actual costs and standard costs. Hewlett-Packard and Jostens, Inc., for example, report their inventories at standard costs. However, if there are significant differences between actual and standard costs, the financial statements must report inventories and cost of goods sold at actual costs.
It is also possible to show the variances in an income statement prepared in the variable costing (CVP) format. To do so, it is necessary to analyze the overhead variances into variable and fixed components. This type of analysis is explained in cost accounting textbooks.
Financial measures (measurement of dollars), such as variance analysis and return on investment (ROI), are useful tools for evaluating performance. However, many companies now supplement these financial measures with nonfinancial measures to better assess performance and anticipate future results. For example, airlines like Delta, American, and United use capacity utilization as an important measure to understand and predict future performance. Newspaper publishers such as the New York Times and the Chicago Tribune use circulation figures as another measure by which to assess performance. Penske Automotive Group, the owner of 300 dealerships, rewards executives for meeting employee retention targets. Illustration 25-28 lists some key nonfinancial measures used in various industries.
Most companies recognize that both financial and nonfinancial measures can provide useful insights into what is happening in the company. As a result, many companies now use a broad-based measurement approach, called the balanced scorecard, to evaluate performance. The balanced scorecard incorporates financial and nonfinancial measures in an integrated system that links performance measurement with a company's strategic goals. Nearly 50% of the largest companies in the United States, including Unilever, Chase, and Wal-Mart Stores, Inc., are using the balanced scorecard approach.
The balanced scorecard evaluates company performance from a series of “perspectives.” The four most commonly employed perspectives are as follows.
1. The financial perspective is the most traditional view of the company. It employs financial measures of performance used by most firms.
2. The customer perspective evaluates the company from the viewpoint of those people who buy its products or services. This view compares the company to competitors in terms of price, quality, product innovation, customer service, and other dimensions.
3. The internal process perspective evaluates the internal operating processes critical to success. All critical aspects of the value chain—including product development, production, delivery, and after-sale service—are evaluated to ensure that the company is operating effectively and efficiently.
4. The learning and growth perspective evaluates how well the company develops and retains its employees. This would include evaluation of such things as employee skills, employee satisfaction, training programs, and information dissemination.
Within each perspective, the balanced scorecard identifies objectives that contribute to attainment of strategic goals. Illustration 25-29 (page 1196) shows examples of objectives within each perspective.
The objectives are linked across perspectives in order to tie performance measurement to company goals. The financial-perspective objectives are normally set first, and then objectives are set in the other perspectives in order to accomplish the financial goals.
For example, within the financial perspective, a common goal is to increase profit per dollars invested as measured by ROI. In order to increase ROI, a customer-perspective objective might be to increase customer satisfaction as measured by the percentage of customers who would recommend the product to a friend. In order to increase customer satisfaction, an internal-process-perspective objective might be to increase product quality as measured by the percentage of defect-free units. Finally, in order to increase the percentage of defect-free units, the learning-and-growth-perspective objective might be to reduce factory employee turnover as measured by the percentage of employees leaving in under one year.
Illustration 25-30 illustrates this linkage across perspectives.
Through this linked process, the company can better understand how to achieve its goals and what measures to use to evaluate performance.
In summary, the balanced scorecard does the following:
1. Employs both financial and nonfinancial measures. (For example, ROI is a financial measure; employee turnover is a nonfinancial measure.)
2. Creates linkages so that high-level corporate goals can be communicated all the way down to the shop floor.
3. Provides measurable objectives for nonfinancial measures such as product quality, rather than vague statements such as “We would like to improve quality.”
4. Integrates all of the company's goals into a single performance measurement system, so that an inappropriate amount of weight will not be placed on any single goal.
SERVICE COMPANY INSIGHT
It May Be Time to Fly United Again
Many of the benefits of a balanced scorecard approach are evident in the improved operations at United Airlines. At the time it filed for bankruptcy, United had a reputation for some of the worst service in the airline business. But when Glenn Tilton took over as United's chief executive officer, he recognized that things had to change.
He implemented an incentive program that allows all of United's 63,000 employees to earn a bonus of 2.5% or more of their wages if the company “exceeds its goals for on-time flight departures and for customer intent to fly United again.” After instituting this program, the company's on-time departures were among the best, its customer complaints were reduced considerably, and the number of customers who said that they would fly United again was at its highest level ever.
Source: Susan Carey, “Friendlier Skies: In Bankruptcy, United Airlines Forges a Path to Better Service,” Wall Street Journal (June 15, 2004).
Which of the perspectives of a balanced scorecard were the focus of United's CEO? (See page 1225.)
DO IT!
Balanced Scorecard
Indicate which of the four perspectives in the balanced scorecard is most likely associated with the objectives that follow.
1. Percentage of repeat customers.
2. Number of suggestions for improvement from employees.
3. Contribution margin.
4. Brand recognition.
5. Number of cross-trained employees.
6. Amount of setup time.
Action Plan
The financial perspective employs traditional financial measures of performance.
The customer perspective evaluates company performance as seen by the people who buy its products or services.
The internal process perspective evaluates the internal operating processes critical to success.
The learning and growth perspective evaluates how well the company develops and retains its employees.
Solution
1. Customer perspective.
2. Learning and growth perspective.
3. Financial perspective.
4. Customer perspective.
5. Learning and growth perspective.
6. Internal process perspective.
Related exercise material: BE25-7, E25-16, and DO IT! 25-4.
Manlow Company makes a cologne called Allure. The standard cost for one bottle of Allure is as follows.
During the month, the following transactions occurred in manufacturing 10,000 bottles of Allure.
1. 58,000 ounces of materials were purchased at $1.00 per ounce.
2. All the materials purchased were used to produce the 10,000 bottles of Allure.
3. 4,900 direct labor hours were worked at a total labor cost of $56,350.
4. Variable manufacturing overhead incurred was $15,000 and fixed overhead incurred was $10,400.
The manufacturing overhead rate of $4.80 is based on a normal capacity of 5,200 direct labor hours. The total budget at this capacity is $10,400 fixed and $14,560 variable.
Instructions
(a) Compute the total variance and the variances for direct materials and direct labor elements.
(b) Compute the total variance for manufacturing overhead.
Action Plan
Check to make sure the total variance and the sum of the individual variances are equal.
Find the price variance first, then the quantity variance.
Base budgeted overhead costs on flexible budget data.
Base overhead applied on standard hours allowed.
Ignore actual hours worked in computing overhead variances.
Solution to Comprehensive DO IT!
1 Distinguish between a standard and a budget. Both standards and budgets are predetermined costs. The primary difference is that a standard is a unit amount, whereas a budget is a total amount. A standard may be regarded as the budgeted cost per unit of product.
2 Identify the advantages of standard costs. Standard costs offer a number of advantages. They (a) facilitate management planning, (b) promote greater economy, (c) are useful in setting selling prices, (d) contribute to management control, (e) permit “management by exception,” and (f) simplify the costing of inventories and reduce clerical costs.
3 Describe how companies set standards. The direct materials price standard should be based on the delivered cost of raw materials plus an allowance for receiving and handling. The direct materials quantity standard should establish the required quantity plus an allowance for waste and spoilage.
The direct labor price standard should be based on current wage rates and anticipated adjustments such as COLAs. It also generally includes payroll taxes and fringe benefits. Direct labor quantity standards should be based on required production time plus an allowance for rest periods, cleanup, machine setup, and machine downtime.
For manufacturing overhead, a standard predetermined overhead rate is used. It is based on an expected standard activity index such as standard direct labor hours or standard machine hours.
4 State the formulas for determining direct materials and direct labor variances. The formulas for the direct materials variances are:
The formulas for the direct labor variances are:
5 State the formula for determining the total manufacturing overhead variance. The formula for the total manufacturing overhead variance is:
6 Discuss the reporting of variances. Variances are reported to management in variance reports. The reports facilitate management by exception by highlighting significant differences.
7 Prepare an income statement for management under a standard costing system. Under a standard costing system, an income statement prepared for management will report cost of goods sold at standard cost and then disclose each variance separately.
8 Describe the balanced scorecard approach to performance evaluation. The balanced scorecard incorporates financial and nonfinancial measures in an integrated system that links performance measurement and a company's strategic goals. It employs four perspectives: financial, customer, internal process, and learning and growth. Objectives are set within each of these perspectives that link to objectives within the other perspectives.
Balanced scorecard An approach that incorporates financial and nonfinancial measures in an integrated system that links performance measurement and a company's strategic goals. (p. 1194).
Customer perspective A viewpoint employed in the balanced scorecard to evaluate the company from the perspective of those people who buy and use its products or services. (p. 1195).
Direct labor price standard The rate per hour that should be incurred for direct labor. (p. 1181).
Direct labor quantity standard The time that should be required to make one unit of product. (p. 1181).
Direct materials price standard The cost per unit of direct materials that should be incurred. (p. 1180).
Direct materials quantity standard The quantity of direct materials that should be used per unit of finished goods. (p. 1180).
Financial perspective A viewpoint employed in the balanced scorecard to evaluate a company's performance using financial measures. (p. 1194).
Ideal standards Standards based on the optimum level of performance under perfect operating conditions. (p. 1179).
Internal process perspective A viewpoint employed in the balanced scorecard to evaluate the effectiveness and efficiency of a company's value chain, including product development, production, delivery, and after-sale service. (p. 1195).
Labor price variance The difference between the actual hours times the actual rate and the actual hours times the standard rate for labor. (p. 1188).
Labor quantity variance The difference between actual hours times the standard rate and standard hours times the standard rate for labor. (p. 1189).
Learning and growth perspective A viewpoint employed in the balanced scorecard to evaluate how well a company develops and retains its employees. (p. 1195).
Materials price variance The difference between the actual quantity times the actual price and the actual quantity times the standard price for materials. (p. 1186).
Materials quantity variance The difference between the actual quantity times the standard price and the standard quantity times the standard price for materials. (p. 1186).
Normal capacity The average activity output that a company should experience over the long run. (p. 1182).
Normal standards Standards based on an efficient level of performance that are attainable under expected operating conditions. (p. 1179).
Standard costs Predetermined unit costs which companies use as measures of performance. (p. 1178).
Standard hours allowed The hours that should have been worked for the units produced. (p. 1191).
Standard predetermined overhead rate An overhead rate determined by dividing budgeted overhead costs by an expected standard activity index. (p. 1181).
Total labor variance The difference between actual hours times the actual rate and standard hours times the standard rate for labor. (p. 1188).
Total materials variance The difference between the actual quantity times the actual price and the standard quantity times the standard price of materials. (p. 1185).
Total overhead variance The difference between actual overhead costs and overhead costs applied to work done, based on standard hours allowed. (p. 1190).
Variance The difference between total actual costs and total standard costs. (p. 1184).
A standard cost accounting system is a double-entry system of accounting. In this system, companies use standard costs in making entries, and they formally recognize variances in the accounts. Companies may use a standard cost system with either job order or process costing.
In this appendix, we will explain and illustrate a standard cost, job order cost accounting system. The system is based on two important assumptions:
1. Variances from standards are recognized at the earliest opportunity.
2. The Work in Process account is maintained exclusively on the basis of standard costs.
In practice, there are many variations among standard cost systems. The system described here should prepare you for systems you see in the “real world.”
We will use the transactions of Xonic to illustrate the journal entries. Note as you study the entries that the major difference between the entries here and those for the job order cost accounting system in Chapter 20 is the variance accounts.
1. Purchase raw materials on account for $13,020 when the standard cost is $12,600.
Xonic debits the inventory account for actual quantities at standard cost. This enables the perpetual materials records to show actual quantities. Xonic debits the price variance, which is unfavorable, to Materials Price Variance.
2. Incur direct labor costs of $31,080 when the standard labor cost is $31,500.
Like the Raw Materials Inventory account, Xonic debits Factory Labor for actual hours worked at the standard hourly rate of pay. In this case, the labor variance is favorable. Thus, Xonic credits Labor Price Variance.
3. Incur actual manufacturing overhead costs of $10,900.
The controllable overhead variance (see Appendix 25B) is not recorded at this time. It depends on standard hours applied to work in process. This amount is not known at the time overhead is incurred.
4. Issue raw materials for production at a cost of $12,600 when the standard cost is $12,000.
Xonic debits Work in Process Inventory for standard materials quantities used at standard prices. It debits the variance account because the variance is unfavorable. The company credits Raw Materials Inventory for actual quantities at standard prices.
5. Assign factory labor to production at a cost of $31,500 when standard cost is $30,000.
Xonic debits Work in Process Inventory for standard labor hours at standard rates. It debits the unfavorable variance to Labor Quantity Variance. The credit to Factory Labor produces a zero balance in this account.
6. Apply manufacturing overhead to production $10,000.
Xonic debits Work in Process Inventory for standard hours allowed multiplied by the standard overhead rate.
7. Transfer completed work to finished goods $52,000.
In this example, both inventory accounts are at standard cost.
8. Sell the 1,000 gallons of Xonic Tonic for $70,000.
The company debits Cost of Goods Sold at standard cost. Gross profit, in turn, is the difference between sales and the standard cost of goods sold.
9. Recognize unfavorable total overhead variance:
Prior to this entry, a debit balance of $900 existed in Manufacturing Overhead. This entry therefore produces a zero balance in the Manufacturing Overhead account. The information needed for this entry is often not available until the end of the accounting period.
Illustration 25A-1 shows the cost accounts for Xonic after posting the entries. Note that five variance accounts are included in the ledger. The remaining accounts are the same as those illustrated for a job order cost system in Chapter 20, in which only actual costs were used.
Helpful Hint All debit balances in variance accounts indicate unfavorable variances. All credit balances indicate favorable variances.
9 Identify the features of a standard cost accounting system. In a standard cost accounting system, companies journalize and post standard costs, and they maintain separate variance accounts in the ledger.
Standard cost accounting system A double-entry system of accounting in which standard costs are used in making entries and variances are recognized in the accounts. (p. 1200).
As indicated in the chapter, the total overhead variance is generally analyzed through a price variance and a quantity variance. The name usually given to the price variance is the overhead controllable variance; the quantity variance is referred to as the overhead volume variance.
LEARNING OBJECTIVE 10
Compute overhead controllable and volume variance.
The overhead controllable variance shows whether overhead costs are effectively controlled. To compute this variance, the company compares actual overhead costs incurred with budgeted costs for the standard hours allowed. The budgeted costs are determined from a flexible manufacturing overhead budget. The concepts related to a flexible budget were discussed in Chapter 24.
For Xonic, the budget formula for manufacturing overhead is variable manufacturing overhead cost of $3 per hour of labor plus fixed manufacturing overhead costs of $4,400 ($52,800 ÷ 12, per Illustration 25-6 on page 1182). Illustration 25B-1 shows the monthly flexible budget for Xonic.
As shown, the budgeted costs for 2,000 standard hours are $10,400 ($6,000 variable and $4,400 fixed).
Illustration 25B-2 shows the formula for the overhead controllable variance and the calculation for Xonic at 1,000 units of output (2,000 standard labor hours).
The overhead controllable variance for Xonic is $500 unfavorable.
Most controllable variances are associated with variable costs, which are controllable costs. Fixed costs are often known at the time the budget is prepared and are therefore not as likely to deviate from the budgeted amount. In Xonic's case, all of the overhead controllable variance is due to the difference between the actual variable overhead costs ($6,500) and the budgeted variable costs ($6,000).
Management can compare actual and budgeted overhead for each manufacturing overhead cost that contributes to the controllable variance. In addition, management can develop cost and quantity variances for each overhead cost, such as indirect materials and indirect labor.
The overhead volume variance is the difference between normal capacity hours and standard hours allowed times the fixed overhead rate. The overhead volume variance relates to whether fixed costs were under- or overapplied during the year. For example, the overhead volume variance answers the question of whether Xonic effectively used its fixed costs. If Xonic produces less Xonic Tonic than normal capacity would allow, an unfavorable variance results. Conversely, if Xonic produces more Xonic Tonic than what is considered normal capacity, a favorable variance results.
The formula for computing the overhead volume variance is as follows.
To illustrate the fixed overhead rate computation, recall that Xonic budgeted fixed overhead cost for the year of $52,800 (Illustration 25-6 on page 1182). At normal capacity, 26,400 standard direct labor hours are required. The fixed overhead rate is therefore $2 per hour ($52,800 ÷ 26,400 hours).
Xonic produced 1,000 units of Xonic Tonic in June. The standard hours allowed for the 1,000 gallons produced in June is 2,000 (1,000 gallons × 2 hours). For Xonic, normal capacity for June is 1,100, so standard direct labor hours for June at normal capacity is 2,200 (26,400 annual hours ÷ 12 months). The computation of the overhead volume variance in this case is as follows.
In Xonic's case, a $400 unfavorable volume variance results. The volume variance is unfavorable because Xonic produced only 1,000 gallons rather than the normal capacity of 1,100 gallons in the month of June. As a result, it underapplied fixed overhead for that period.
In computing the overhead variances, it is important to remember the following.
1. Standard hours allowed are used in each of the variances.
2. Budgeted costs for the controllable variance are derived from the flexible budget.
3. The controllable variance generally pertains to variable costs.
4. The volume variance pertains solely to fixed costs.
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