College of San Mateo

Accounting 131

Rosemary Nurre


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Chapter 10

Standard Costs and the Balanced Scorecard

Learning Objectives

  1. Explain how direct materials standards and direct labor standards are set.
  2. Compute the direct materials price and quantity variances and explain their significance.
  3. Compute the direct labor rate and efficiency variances and explain their significance.
  4. Compute the variable manufacturing overhead spending and efficiency variances.
  5. Understand how a balanced scorecard fits together and how it supports a company's strategy.
  6. Compute the delivery cycle time, the throughput time, and the manufacturing cycle efficiency (MCE).

Lecture Notes

A.Standard Costs-Management by Exception. A standard is a benchmark or "norm" for measuring performance. In managerial accounting, standards relate to the cost and quantity of inputs used in manufacturing goods or providing services.

1.Quantity standards. Quantity standards indicate how much of an input, such as labor time or raw materials, should be used in manufacturing a unit of product or in providing a unit of service. To measure performance, actual quantities used are compared to standard quantities allowed.
2.Cost standards. Cost standards identify how much each unit of input should cost. Actual costs of inputs are compared to these standards.

B. Setting Standard Costs. Standards should be set so that they encourage efficient operations.

1. Ideal versus practical standard. Standards tend to fall into one of two categories-either ideal or practical.
  • Ideal standards allow for no machine breakdowns or work interruptions, and require that workers operate at peak efficiency 100 percent of the time. Since ideal standards are rarely met, most managers believe they tend to discourage even the most diligent workers.
  • Practical standards are "tight, but attainable." They allow for normal machine downtime and employee rest periods and can be attained through reasonable, but highly efficient, efforts by the average worker.

2. Setting direct materials standards. Separate standards are prepared for the price and quantity of each type of material input.

  • The standard price per unit for direct materials should reflect the final, delivered cost of the materials, net of any discounts taken. The standard price is for a particular grade of material, purchased in particular lot sizes, and delivered by a particular type of carrier.
  • The standard quantity of direct materials per unit of output in a traditional standard cost system reflects the amount of material going into each unit of finished product, as well as an allowance for unavoidable waste, spoilage, and other normal inefficiencies. However, it is worth pointing out that some experts argue that "normal" inefficiency can no longer be tolerated and that firms that build waste into their operations will ultimately face serious problems competing with firms that don't.

3. Setting direct labor standards.

  • The standard rate per hour for direct labor should include not only wages, but also fringe benefits and other labor-related costs. Ordinarily, the standard rate is an average that assumes a specific mix of higher and lower paid workers.
  • The standard direct labor-hours per unit of output is the direct labor time allowed to complete a unit of product. In traditional standard cost systems this standard time includes allowances for coffee breaks, personal needs of employees, clean-up, and machine downtime.

4. Setting variable manufacturing overhead standards. Standards for variable manufacturing overhead are usually expressed in terms of direct labor-hours or machine-hours. The rate represents the variable portion of the predetermined overhead rate that is discussed in Chapter 3. The standard hours for variable overhead represent the standard hours for whatever base is used to apply overhead cost to products or services. If direct labor-hours is the basis for applying overhead to products, then the quantity standard for variable manufacturing overhead will be the quantity standard for direct labor.

5. Standard cost card. A standard cost card is a summary of the standard costs of inputs required to complete one unit of product. It lists for each input the standard purchase price per unit of input, the standard quantity of the input allowed per unit of product, and the standard cost (purchase price per unit of input times the standard quantity of the input allowed for each unit of product).

6. Standards and budgets. The most important distinction between a standard and a budget is that a standard is a unit amount, whereas a budget is a total amount. In effect, a standard can be viewed as the budgeted cost for one unit.

C. A General Model for Variance Analysis. A variance is the difference between standard prices and quantities on the one hand and actual prices and quantities on the other hand. A general model can be used to describe the variable cost variances. This model, which isolates variances into price variances and quantity variances, is found in Exhibit 10-3.

1. Price variance. The price variance is the difference between the actual quantity of inputs at the actual price and the actual quantity of inputs at the standard price. As discussed later, the "actual quantity of inputs" ordinarily refers to the actual quantity of inputs purchased, which may differ from the actual quantity of inputs used.

2. Quantity variance. The quantity variance is the difference between the actual quantity of inputs used at the standard price and the standard quantity of inputs allowed for the actual output at the standard price. The "standard quantity allowed for the actual output" means the amount of the input that should have been used to produce the actual output of the period. It is computed by multiplying the standard quantity of input per unit of output by the actual output.

NOTE: The general model presented in Exhibit 10-3 serves as the basis for much of the remaining discussion in this chapter. Please review it carefully.

3. Alternative methods. As an alternative to the general model, variances can be computed by the use of formulas. The formulas for the price variance are:

Price (rate) variance = (AQ ( AP)) - (AQ ( SP))


Price (rate) variance = AQ (AP - SP)

The formulas for the quantity variance are:

Quantity (efficiency) variance = (AQ ( SP)) - (SQ ( SP))


Quantity (efficiency) variance = SP (AQ - SQ)


AQ = Actual quantity of inputs purchased (or used)

AP = Actual price per unit of inputs purchased

SP = Standard price per unit of input

SQ = Standard input allowed for the actual output

D. Computation and Interpretation of Standard Cost Variances. Since direct material, direct labor, and variable overhead are all variable manufacturing costs, the process of computing price and quantity variances for each cost category is the same. The general model can be used in each case to compute the variances. The only complication is deciding in each case whether the actual quantity of inputs refers to the actual quantity purchased or the actual quantity used.

1. Direct material variances.
a. The materials price variance is the difference between what is paid for a given quantity of materials and what should have been paid according to the standard. Most firms compute the material price variance when materials are purchased rather than when the materials are placed into production. Generally speaking, the purchasing manager has control over the price to be paid for goods and is therefore responsible for any price variance.
For purposes of control, it is best to recognize the variance immediately rather than wait until the materials are withdrawn for use in production. Also, if the material price variance is recognized at time of issuance to production rather than at time of purchase, then someone must keep track of the actual cost of each item until it is used. If the variance is recognized when the materials are purchased, then the materials inventories can be carried at standard cost-which enormously simplifies the bookkeeping.

NOTE: Don't be bothered by the "untidiness" that results from basing the materials price variance on the amount of materials purchased and the materials quantity variance on the amount of materials used. The sum of the two variances does not equal the difference between the actual cost of materials purchased and the standard materials cost of the actual output. The text explains why the materials price variance is based upon the quantity that is purchased.

b. The materials quantity variance is the difference between the quantity of materials used in production and the quantity that should have been used according to the standard-all multiplied by the standard price per unit of input. Ordinarily, the materials quantity variance is the responsibility of the production department. However, there may be times when the purchasing department is responsible for an unfavorable material quantity variance due to the purchase of inferior quality materials.

NOTE: The standard quantity allowed can be computed. It is first necessary to know the actual output of the period. The standard quantity allowed is the amount of input (e.g., materials) that should have been used to complete the period's output. For example, if the standard quantity is 5 pounds of materials for one unit of product, and if 1,000 units are completed during a period, then the standard quantity allowed is 5,000 pounds (5 pounds per unit x 1,000 units).

2. Direct labor variances.

a. The labor rate variance measures any deviation from standard in the average hourly rate paid to direct labor workers. Students often wonder how there can be a labor rate variance since firms generally know each employee's wage rate in advance. A labor rate variance can arise for a number of reasons. The mix of workers, and hence of lower and higher wage rates, can be different from what was planned due to absences, changes in the composition of the work force, and a variety of other circumstances. Additionally, labor rate variances can occur if there is overtime.

b. The quantity variance for direct labor is called the labor efficiency variance. Traditionally, this has been the most closely monitored variance by management. The usefulness of this variance is questionable, however, due to changes in employment policies and in production processes. When the employment force is flexible and can be adjusted to changes in workloads at will, the main causes of the labor efficiency variance include poorly trained workers, poorly motivated workers, poor quality materials which require more labor time and processing, faulty equipment which causes breakdowns and work interruptions, and poor supervision. However, in many firms, there is very little ability to adjust the work force to the workload in the short-term. In such firms, the major cause of a labor efficiency variance is likely to be fluctuations in demand for the firm's products rather than the efficiency with which workers do their jobs.

When demand is down or when a workstation is not a bottleneck, excessive emphasis on labor efficiency variances can create tremendous pressure to build inventories. Take the case of a workstation that is not a bottleneck. If the labor force is basically fixed and the standards are tight, the workstation can only attain a favorable labor efficiency variance by producing at capacity. However, if the workstation is not the bottleneck and it is operating at capacity, it will produce more output than the bottleneck can process. That will result in work in process inventory that cannot be completed. As the JIT movement attests, work in process inventory is the enemy of efficient operations. It leads to long and erratic manufacturing cycle times, high defect rates, obsolescence, and high overhead due to expediting and the problems of coordinating production schedules amongst the general chaos on the factory floor. A very strong argument can be made that the labor efficiency variance should be unfavorable in workstations that are not bottlenecks when the work force is fixed.

NOTE: THE GOAL, by Eliyahu M. Goldratt and Jeff Cox, North River Press, is a popular and highly readable account of a factory in trouble and how a manager is able to turn the situation around. Many of the problems encountered in the factory stem from an inappropriate emphasis on labor efficiency variances. It provides you with some idea of the real problems faced by managers. It also underlines the importance of management accounting in organizations.

3. Variable overhead variances.

a. The variable overhead spending variance is computed as follows when the variable overhead rate is expressed in terms of direct labor-hours:
Variable overhead spending variance =

Actual overhead cost - Actual input hours ( Variable overhead rate)

The variable overhead spending variance compares actual spending on variable overhead to the amount of spending that would be expected, given the actual direct labor-hours for the period. The critical assumption is that variable overhead spending is proportional to the actual direct labor-hours. The usefulness of this variance depends upon the validity of this assumption. If in fact there is little relationship between actual direct labor-hours and the optimal level of variable overhead spending, then this variance has little meaning.

b. The variable overhead efficiency variance is computed as follows when the variable overhead rate is expressed in terms of direct labor-hours:

Variable overhead efficiency variance =

(Actual hours - Standard hours allowed) ( Variable overhead rate)

Note the similarity between the direct labor efficiency variance and the variable overhead efficiency variance. In both cases, the actual direct labor-hours are compared to the standard direct labor-hours allowed for the actual output. The only difference between the variances is the standard rate that is applied to difference between the actual and standard hours. In the case of the direct labor efficiency variance, the rate is the standard labor rate. In the case of the variable overhead efficiency variance, the rate is the standard (predetermined) variable overhead rate per direct labor-hour. Therefore, these two variances really measure the same thing. Those who criticize the labor efficiency variance as irrelevant or counter-productive would likewise criticize the variable overhead efficiency variance.

E. Variance Analysis and Management by Exception. Management by exception means that the manager's attention should be directed towards areas where things are not proceeding according to plans. Standard cost variances signal performance different from what was expected. Since not all variations require the attention of management, some method of identifying those variations that do require attention is required. Statistical analysis can be useful in this task and the basics of this approach are sketched in the text.

F. Potential Problems with Using Standard Costs. Some of the potential disadvantages of standard costs have been mentioned in passing above. A more complete list follows:

1. Standard cost variance reports are usually prepared on a monthly basis and are released long after the end of the month. As a consequence, the information in the reports may be so stale that it is almost useless. It is better to have timely, frequent reports that are approximately correct than to have untimely, infrequent reports that are very precise but too old to be of much use. Some companies are now reporting variances and other key operating data daily or even more frequently.

2. If managers are insensitive and use variance reports as a club, morale may suffer. There should be positive reinforcement for work well done. Management by exception, by its nature, tends to focus on the negative. Moreover, if variances are used as a club, subordinates may be tempted to cover up unfavorable variances or take actions that are not in the best interests of the company to make sure the variances are favorable. For example, workers may put on a crash effort to increase output at the end of the month to avoid an unfavorable labor efficiency variance. During such crash efforts, quality may not be a major concern. It is claimed that in the old Soviet Union, workers used hammers instead of screwdrivers at the end of the month to meet production quotas.

3. Labor quantity standards and labor efficiency variances make two important assumptions. First, they assume that the production process is labor-paced; if labor works faster, output will go up. However, output in many companies is no longer determined by how fast labor works; rather, it is determined by the processing speed of machines. Second, these computations assume that labor is a variable cost. However, as discussed in earlier chapters, in many companies direct labor may be more of a fixed cost than a variable cost. And if labor is a fixed cost, then an undue emphasis on labor efficiency variances creates pressure to build excess work-in-process and finished goods inventories as discussed above. If a workstation is not a bottleneck, its capacity exceeds the capacity of the bottleneck. If every workstation is being evaluated based on its labor efficiency variance, then every workstation will attempt to produce at capacity. But if the work stations in front of the bottleneck produce at capacity, the inevitable result will be a build up of work in process inventories in front of the bottleneck. This reasoning applies to any two successive workstations with differing capacities. If the first work station has greater capacity that the second work station and attempts to produce to its capacity, the result will be ever increasing piles of work in process inventory in front of the second work station.

4. In some cases, a "favorable" variance can be as bad or worse than an "unfavorable" variance. For example, there are standard doses for vaccines. If there is a "favorable" variance, it means that less vaccine was used than the standard specifies. The result may be an ineffective inoculation.

5. There may be a tendency with standard cost reporting systems to emphasize meeting the standards to the exclusion of other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction.

6. Continual improvement-not just meeting standards-may be necessary to survival in the current competitive environment. For that reason, some companies focus on the trends in the standard cost variances-aiming for continual improvement rather than just meeting the standards.

G. Balanced Scorecard. A balanced scorecard consists of an integrated set of performance measures that are derived from the company's strategy and that support the company's strategy throughout the organization. Since each company's strategy and operating environment is different, each company's balanced scorecard will be unique. However, they will have some common characteristics.

1. Common characteristics of balanced scorecards.
a. It should be possible, by examining a company's balanced scorecard, to infer its strategy and the assumptions underlying that strategy. (See Exhibit 10-13 for an example.)

b. The balanced scorecard should emphasize continuous improvement rather than just meeting present standards or targets.

c. Some of the performance measures on the balanced scorecard should be non-financial. Financial measures tend to be lagging indicators, rather than leading indicators. Non-financial measures are also often easier to understand for most employees.

d. While there will be a comprehensive scorecard for the entire company, the scorecards for individuals should contain only those performance measures they can actually influence. As you go lower in the organization, you are likely to observe fewer performance measures on individuals' scorecards and that more of them will be non-financial.

e. Most, but certainly not all, balanced scorecards will contain performance measures that fall into at least four main categories: financial, customer, internal business process, and learning and growth. The ultimate objectives of the organization are usually financial, but better financial results cannot be attained without improving customers' perceptions of the company's products and services. In order to improve customers' perceptions of products and services, it is usually necessary to improve internal business processes so that the products and services are actually better. And in order to improve the business processes, it is necessary that employees learn.

2. The balanced scorecard as a motivation and feedback mechanism. The performance measures on the balanced scorecard provide motivation and feedback for improving. If an employee takes an action to improve a performance measure and the measure actually improves, the employee is encouraged. If the performance measure does not improve, there is an opportunity for learning. The employee can adjust what he or she was doing and try again to see if there is improvement. Learning to shoot baskets is a good analogy. If you could not see whether a shot actually went into the basket, you would quickly lose interest and certainly would not be able to improve. Only by seeing what works and what does not work can you improve.

3. The balanced scorecard and a reality check for the company's strategy. Suppose employees work very hard and make dramatic improvements in internal business processes but there is no increase in customer satisfaction or in financial results. Rather than throwing up one's hands in despair, this is a golden opportunity to examine the company's strategy. If improvement in one area does not lead to expected improvement elsewhere, there may be something wrong with the theory underlying the strategy. Indeed, strategy can be thought of as hypotheses about the effects of particular actions on desired outcomes. If those desired outcomes do not occur, the hypotheses perhaps should be discarded and the strategy reconsidered. If there is no attempt to systematically collect data that can disprove the assumptions underlying the company's strategy, the company may stagger on indefinitely-unaware that its cherished assumptions are no longer valid. This is an extremely important aspect of the balanced scorecard that should be emphasized.

4. Some internal business process performance measures. Exhibit 10-12 in the text contains a rather long list of potential performance measures that could be included on balanced scorecards. These should be viewed as examples only. Most companies are likely to use some of these measures or measures that are very similar to some on the list. Most companies will add many other performance measures that are not on the list. As a consequence, there should not be a great deal of emphasis on this list. Nevertheless, there are several measures of internal business process performance on the list that are quite common and which are not self-explanatory.

a. Delivery Cycle Time. This is the total elapsed time between when an order is placed by a customer and when it is shipped to the customer. Part of this time is wait time that occurs before the order is placed into production. The remainder of this time is the throughput time, which is defined below.

b. Throughput (Manufacturing Cycle) Time. This is the total elapsed time between when an order is initiated into production and when it is shipped to the customer. It consists of process time, inspection time, move time, and queue time. The only element that adds value is processing time. Inspection time, move time, queue time, and their associated activities do not add value and should be minimized.

c. Manufacturing Cycle Efficiency (MCE). MCE is the ratio of value-added time (i.e., process time) to total throughput time. It represents the percentage of time an order is in production in which useful work is being done. The rest of the time represents non-value-added time (i.e., inspection time, move time, and queue time).