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Standard Costs and the Balanced
Scorecard
Learning Objectives
- Explain how direct materials standards and direct labor standards
are set.
- Compute the direct materials price and quantity variances and explain
their significance.
- Compute the direct labor rate and efficiency variances and explain
their significance.
- Compute the variable manufacturing overhead spending and efficiency
variances.
- Understand how a balanced scorecard fits together and how it supports
a company's strategy.
- 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))
or
Price (rate) variance = AQ (AP - SP)
The formulas for the quantity variance are:
Quantity (efficiency) variance = (AQ ( SP)) - (SQ (
SP))
or
Quantity (efficiency) variance = SP (AQ -
SQ)
Where:
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).
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