208. Petersen Pottery ANALYSIS OF OPERATIONS ‘After 6 months of operations using the new cost system Petersen was disturbed over the Tack of attention paid to the standards. He felt that the potters were just too set in their ways to pay any attention to the “confusing” new system, As one of the potters observed, “I have been making these fixtures a lot longer than these new ideas had been around, and I don’t see how a bunch of numbers that some hot-shot accountant puts together are going to help me make any berter toilets.” The result was that although the standards existed, they were seldom met. in reviewing the June production results, the following actual costs were noted in connection with manufacturing 1145 toilets: Materials Purchased Clay 30,000 Ib @ §.92/lb Glaze 6,000 Ib @ $.78/Ib Materials Used Clay 28,900 Ib Glaze Direet Labor Molding 1.200 hr @S15.25/hr Glazing 600 hr @ $15.00he Overhead Assigned to Toilets: $6,100 (82,300 variable cost and $3,800 fixed cost) ‘The sales manager was unhappy that production was 55 units below plan. ‘The cost ‘accountant was unhappy about continuing unfavorable variances. Before proceeding with further analysis, Petersen met with his most experienced master potter, Jim Sedgefield, to discuss the variances from the standards, He was seriously considering implementing a new and much faster “pressure casting” mold system to replace the existing manual system, When Sedgeficld arrived Clive explained the problem: “Sim, you agrecd when we set them up that the standards are reasonable and yet you never meet them. It looks like we will have unfavorable variances again this mouth as well as more missed shipping dates.” Sedgefield was not impressed. “Well Clive,” he said, “T newer have linderstood this system at all. Why don’t you ask that fast-talking, accountant to explain the variances? He seems to know what these numbers mean, AILI know is, we seemed (o spend all month fisssing with that new brand of clay you said was going to be cheaper for us. Do you want mee to make lots of toilets ‘or good toilets?” QUESTIONS Analyze the variances for the month using whatever Format you like. ‘What conclusions are suggested regarding cost performance for the month? ‘What suggestions do you have for Mr. Petersen regarding his new standard cost system?A Note on Computing Manufacturing Cost Variances For use with Petersem Pottery case 1 “PRIME” COSTS ‘The tenm “prime” costs refers to those costs which can be directly identified with one unit of product. ‘Another term for “prime” cost is “direct” cost or “variable” cost, You will often hear the terms ‘direct material cost or “direct” labor cost. Traditionally, labor has been considered a prime cost by most companies, “Indirect” material and “indirect” labor cosis are considered to be part of manufacturing overhead or “burden” rather than part of prime cost. Example of these four cost categories are shown belo Cost Category Cost Classification Example Direct Labor Prime Cost Cost for a worker's time spent assembling a product, Inditect Labor Overhead Cost Cost for a worker's time spent repairing manufacturing equipment Direct Material Prime Cost Cost of stee! used in manufseturing an automobile Indirect Material Overhead Cost Cost of supplies used in maintaining manufacturing equipment ‘Today, many companies treat manufacturing Jubor cost more as fixed than as_volume dependent, In this case, the only “prime” or “direct” cost is raw material rhe standard for any’ element of prime cost Involves two components: a prieé component and a quantity component. The standard cost isthe standard quantity to be used multiplied by the standard pice per unit of measure. For example, if an clectrie motor contains four bushings andl each bushing ‘Should cost $.25, then the standard cost for bushings is $1.00 (standard quantity of 4 X the standard price per unit of $.25). Variances are usually computed for each of the two components. The formulas for calculating the varlances are as follows: Price variance (PW)= (AP - SP) X AQ ‘Quantity variance (QV) (AQ - SQ) K SP Total variance (TW)- PV + QV where SP = standard price AP = actual price 8Q= standard quantity AQ= actual quantitySince the total variance is the difference between the standard cost allowance (SP X SQ) and the actual cost incurred (AP X AQ), you should be able to verify for yourself that the price and quantity variance in the above formulas do sum to the total variance. We can illustrate these calculations with. the following example which assumes that both material and Jabor cost are volume dependent Calon! ‘Standacel per Vit 2 pounds per unit at $1.00 per ‘pound = $2.00 por unit 3 hours per unit at $4.00 per hour = 512.00 per unit Production 10 units. Therefore, the standard cost allowanec: {s $20 for material and $120 for labor Actual Costs Material Used 25 pounds which were purchased at a cast of $.80 per pound, fora cost of $20, Labor Used 25 hours at an average sate of $5.00 per hour, for a cost of $125. Material Price variance: ($1.00- $.80) ‘X25 lb = $5 Favorable Quanity variance: (20-25) $1.00/ib = $5 Unfavorable ‘Votal variance: $20 - $20 Labor Price variance: (84 - $5) 25 25. Unfavorable Quantity variance: (30 - 25) X Safhr = $20 Favorable Total variance: $25U + $20F= $5U = $120 - $125 We suggest that you pot worry about whether 10 put standard or actual first in the formulas or about trying to keep teack of whether a negative result is Tavorable ot tnfavorable. Instead, just think about whether the direction of the variance is good or bad and forget about algebraic signs. A Complication “The Joint” Variance. Ifyou Took closely at the variangc formulas above, you will see that quantity variance is computed using standard prices While, the price variance is computed using actal quantities. ‘(bis Is logically inconsistent, but it makes Sense to most people. Most people feel that price Petersen Pottery — Note on CMCV_ fwuotuations should not be considered when measuring the variance due to quantity fluctuations-—vary only oe component at atime, However, most people also feel that the price variance should be measured over the actual quantities for which the price difference obtains, not the Gandard quantities. Some people do not like this logical inconsistency. They prefer to vary only one component at fitime in both the price and quantity variance caleulations. ‘They then set up a third variance Goint variance) caused by the: joint fluctuation in both prices and quantities. ‘Under this approach the formulas are as Follows: PV=(AP -SP) XSQ QV =(AQ- SQ) XSP IV =(AP- SP) K (AQ- SQ) TV=PV+QV1IV can be illustrated graphically as follows, assuming both price and quantity variations are unfavorable: ‘Two. Variances Approach ‘Actual |—_—__—___———_ Price Price Variance Standard Price Standard ‘Quantity Cost Varianee Standard Usage Actual Usage ees Approach Actual |_————,———— —_q Price Price Joint Variance Variatice Standart Price Standard Quantity L Cost ‘Variance Standard Usage Actual Usage Ik is impossible to give a commonsense interpretation 10 the joint variance when one of the two ‘components varies favorably and the other varies unfavorably. Furthermore, most authors believe that purchasing agents should be sessed for price variations on quantities actually purchased but that pfocuction managers should be assessed for quantity differences scaled with standard prices (ignoring price fluctuations). For these reasons, they favor the simpler, two variance approach. “The two variance equality set up in this note (PY + QV = TV) is often violated in practice in regard. to tpalerial variances, ‘Thal is, many firms prefer to compute the price variance over quantities: purchased and the quantity variance over quantities wed. Since purchase and usage quantities often differ in any given period, thePetersen Pottery — Note on CMCV two variances cannot be aggregated algebraicly. They can, however, still be combined for cost reporting purposes to get a picture of purchasing and usage variances together. Suppose, for example, that in our earlier illus- tration material purchases totaled 30 pounds at $,80 even though only 25 pounds were used in production. The ‘material variance calculation could then be as follows: Price variance: ($1.00 - $.80) X 30 Ib = $6 Favorable Quantity variance: (20 - 25) X $1.00/Ib= $5 Unfavorable ‘Total variance: S6F + $5U = SIF # $20 - $20 A labor price varianee is often called a “labor rate” variance and a labor quantity variance is often called a “labor efficiency” variance. A material quantity variance is often called a “material usage” variance and a material price vatance is often called a “purchase price” variance. Ul, OVERHEAD COSTS Conventional Overhead Budgets. Budgets for piime costs hinge on unit-level standard costs. Ones standard prime costs per unit are determined, the budget for any given period is just the standard cost per unit times the number of units produced. A simple approach like this works becanse prime costs are variable costs, ‘The cost allowance or budget thus varies directly as production volume varies. Because manufacturing overhead costs typically do not vary directly with volume, it is. a more difficult tasle to determine allowable overhead at any given level of production. Fixed Budgets. One approach to overhead budgeting ignores the volume dependence issue entirely. ‘This approach is called fixed overhead budgeting. Under fa fixed-budget approach, management determines the amount of overhead which should be incurred at the normal or most likely production level. This expense total becomes the budget against which cost performance is measured, regardless of the level of production output actually achieved. To the extent that manufacturing ‘overhead costs do vary with production, the fixed-budget approach does not yield meaningful variance data when actual output varies from planned output. There is no conceptual support for a fixed-budget approach to manufacturing, overhead, but many companies stilluse it. Flexible Budgets. The more conceptually sound approach to determining ovethead standards in conventional cost aecounting is called flexéble budgeting ‘A flexible manufacturing overhead budget specifies allowable cost at each possible output level. Once & period is over and the actual production volume is known, the “flexed” cost allowance is determined by reference to the flexible budget for that level of output. This is a direct 21 parallel to the way a budget for direct material is determined, If all manufact-uring overhead is either pure “variable” or pure “fixed,” @ flexible budget is just a formula of the following type: Budget allowance = a+bx where a= fixed overhead costs for the period b= variable overhead costs per unit x= units produced during the period ‘An example of a simplified exible budget is siown below: Capacity “Normal” Utilzation:! 40% .. 80% .. 100% Units Produced 4,008,000 "10,000. Allowed Overhead Cost Behavi Depreciation $1,000 $1,000 $1,000 Pure non-variable or “fixed” Supervision 300 1,000 1,500 “Step” cost? Supplies 400 "800 1,000 Pore variable at 8.10 per unit Power 600 800 900 Semivariable ($400 + 5.05 per unit) Total $2,500 $3,600 $4,400 1 Its assumed that volume would never fall below 40% of capacity or above 100% 2A step” cost is one which doesn't vary directly with production but does increase in lump-sum jumps when volume rises substantially, An example would be adding a second foreman when volume rose to the level that a second shift was needed. Flexible Budget Formula Up to 80% of capacity: $1,900 + $.15 per unit ‘Above 80% utilization: $2,400 + $.15 per unit Overhead Absorption Under GAAP or IRS rules, manufacturing overhead is considered to be part of product costs. It is therefore necessary to find some way of charging or “absorbing” manufacturing overhead into inventory. However, the simple approach of charging actual manufacturing ‘overhead each period directly to work-in-process (WIP) inventory is usually not considered to be an acceptable approach for two reasons: 1. Variances are not considered to “add value” to the inventory, Thus, overhead variances are not considered to be product costs. Thus, only allowable ‘overhead is to be “inventoried.” 2. Volume considerations also affect the decision of how ‘much overhead to absorb in inventory. Suppose, for ‘example, that depreciation is $1,000 per period. Alsosuppose that 1 unit is produced in period 1 and 1,000 units are produced fp period 2. Tt doesn't secm “fait” to most accountants to say that in period one, the one unit caries a cost of $1,000 for depreciation ($1,000 depreciation + 1 unit) and in period two, each unit only $1 ($1,000 depreciation + 1,000 unit). A_unit cant really be “more valuable” just because fewer ‘were produced that month “Fair” allocation of depreciation to inventory seems to requite a concept of “normal” volume. The $1,000 dopreciation expense is incurred as a “reasonable” charge on the assumption that some reasonable or normal number of units will be produced on the equipment. It is this normal volume level over which the planned overhead should be spread, so. the argument goes. For these two reasons, conventional practice for charging manufacturing overhead into inventory is to use ‘a “normal absorption rate.” This rate is computed as planned overhead cost at normal production volume (per the flexible budget) divided by that normal volume. In the ‘example above, the normal volume is 8,000 units (80% of capacity). AC this level of output, budgeted overhead is $3,600, The “normal absorption rate” is thus $3,600/8,000, or $.45 per unit. ‘in single-product firms, output can be expressed in units of product. In multiproduct firms, however, itis necessary to set some other measure of capacity ‘iilzation, such #5 labor hours, labor dollars, or machine hours. The choice of a volume measure in a particular pusiness should be based on which variable best measures the lovel of capacity utilization for that business Of course, the notion that anyone measure of activity can capture the essence of capacity utilization geross manufacturing departments ignores the richness ‘which activity-based costing tries to capture ‘The accounting works as follows. A T-account js established in the books of account called “Factory overhead” or “burden” or something equivalent. Actua) manufacturing overhead expenses are charged (debited) to {his ‘T-account. Overhead is absorbed into inventory by crediting the “factory overhead” account and debiting the Wworkcin-process inventory in an amount equal to the absorption rate times the actual volume attained, In our example, if actual volume was 6,000 units, $2,700 of overhead would be charged to WIP (6,000 X 8.45). “This absorption process will only “clear” the factory overhead account if pwo conditions are both met 1. factual volume equals planned volume. ‘Manufacturing overhead cost does not vary: directly ‘with production. The absorption rate, however, is a pure variable rate. Thus, absorbed overhead will only Petersen Pottery — Note on CMCV. equal planned overhead at one particular volume Jevel—that level used in computing the absorption rate 2. factual overhead expenses equal planned expenses per the flexible budget, Since only budgeted ‘overhead ig absorbed, any differences between “budgeted costs and actual costs will not be “cleared” from the factory overhead T-account, ‘At the end of any accounting period, there is usually a residual balance in the factory overhead account resulting fom failure to meet one or both of these two conditions. ‘This end-of-period residual in the factory overhead T- account is sometimes called the “book” overhead variance ‘because it is what shows up in the books of account. It is also sometimes called the total overhead variance. ‘Normal accounting practice is to charge this variance to cost of goods sold for the month as a period expense. ‘Analyzing the Total Overhead Variance Using the same example from above with actual production of 7,000 units, we can produce the following cost table: Flexible Budget Allowance at Actual Actual Volume of Exponseat Spending Cost tem 7.000 Units _Actual Volume __Varlanes Depreciation $1,000 $1,100 sioou Supervision 1,000 1,050 sou Supplies 700 690 10F Power 70 79 20 Total $3,450 mao Sua ‘Manufacturing Overhead Absorbed into Inventory "7000 X S.45 = $3.150___ |As shown in the table, the difference between ‘acual overhead incurred and the flexible budget at this evel of output is called the ovethead “spending” variance. It measures cost control performance under the assumption that the flexible budget is a usefull cost benchmark, ‘The total variance which shows up in the T- account is equal to the difference between actual overhead {the debits) and absorbed overhead at actual volume tthe sredit), In this example, the total variance is $460U (3610 = 3150). ‘The variance which is useful in measuring cost ‘control effectiveness (the spending, varkance) is equal to the difference between actual overhead and allowed overhead at actual volume. For the example, this 1s‘Petersen Pottery — Note on CMCV $1G0U, Tn order to present an analysis which “balances,” ‘cost accountants need to have some name for the difference between the total variance and the spending variance, Using a little algebra, we can see that the quantity for which we need # name, “the plug,” is allowed OHL- absorbed OH: Actual Allowed Actual Minus = + = Minus = Minus Allowed Absorbed Absorbed Spending Total Variance «+ | Pug? = = Varian $1600 +9300U = $460 Regarding the plug, we have already observed that allowed OH will only equal absorbed OF when #he firm operates at normal volume, Why? Because budgeted overhead does not vary directly as production varies, but absorbed overhead is purely variable, by convention. ‘The absorption rate is set to just absorb into inventory the planned overhead when the firm actually operates at its normal volume, The idea here is that the normal absorption rate is the normal amount of manufacturing overhead cach unit should carry. Standard (absorbed) overhead cost per unit, for purposes of valuing inventories, is thus equal to a proportional share of normal overhead when production volume is at normal levels. ‘The plug variance (allowed OM - absorbed OH) results from the difference between planned and actual production volume. It is usually called the “production volume variance.” ‘The dollar amount of this production volume variance fas no particular management significance whatsoever. The dollar amount ig just the plug required to reconcile a managerially significant number (the spending variance) to a number which shows up in the income statement (the total variance), The production volume variance does result ‘rom variation between planned and actual production ‘volume. In this sense, the name is appropriate. However, the amount is not managerially useful—the amount is just aplug. For our example, the amount is $300U! as shown | above. Going one step further, we can talk about what comprises the “plug.” It does not include any variable ‘overhead because items which are directly variable with | production are treated identically in the absoxption rate | GAS per unit) and in the flexible budget (6.15 per anit) “They thus cancel out in computing the difference between allowed and absorbed cost, In our illustration, for “ exanmple, the absorption rate of $.45 per unit includes $.15 | of variable cost and the flexible budget also includes $.15 per unit of variable cost ($.10 for supplies and $.05 for power). At acmal volume ‘of 7,000 units, therefore, both = the allowed OH of $3,450 and the absorbed OH of $3,150 include $1,050 of variable cost. This $1,050 thus does not contribute anything to the difference between $3,450 and $3,150. The difference is the fixed-cost portion of the absorption rate (8.30) times the unfavorable volume fluctaation of 1,000 units, or $300U. The §.30 fixed cost portion of the absorption rate is equal to the $2,400 of planned fixed overhead at normal volume divided by the volume measure of 8,000 units. When operating at the 7,000 unit level, we are allowed $2,400 of fixed manufacturing overhead, but we only absorb $2,100 (7,000 x$.3). Il. MANAGERIAL USE OF VARIANCES Itis very widely assumed in “cost accounting circles” that variances calculated according to the techniques explained here in Parts I and JI represent useful management information. We will summarize here the particular slant on this point of view from four of the “top 20” MBA programs as reflected in textbaoks written by faculty members there, ‘A. Stanford Business School (Professor Charles Horngren) “Standard costs are the building blocks of budgeting and feedback system. A standard cost is a carefully predetermined cost that should be attained.” “jp practice, direct materials and direct labor are often said to be controlled with the help of standard costs.” perfect standards are expressions of the absolute minimum costs possible under the best conceivable conditions, No provision is made for waste, spoilage, machine breakdowns, and the like. Those who favor this approach maintain that the resulting unfavorable variances will constantly remind managers of the perpetual need for improvernent in all phases of operations. Perfect standards are not widely used, however, ‘because they have an adverse effect on. employee motivation” “Currently attainable standards are costs that can be achieved by a specified level of effort Allowances are made for normal spoilage, waste, and nonproductive time, ‘There are at least two popular interpretations of the meaning of ‘currently attainable’ standards. The first interpretation has standards set just tightly enough so thal employees regard their fulfillment as highly probable if normal effort and diligence are exercised, ‘That is, variances should be negligible. A second interpretation of eurrently atainable standards is that standards are set24 tightly. That is, employees regard their fulfillment as possible, though unlikely.” “Managers responsible for variances should be required to explain them, In addition, managers who have control over the causes of the variances should be held accountable for avoiding unfavorable variances of correeting the factors causing them. The primary function of variances is explanation. The main goal is to understand what is affecting costs and revenues so that managers can make better decisions in the future.” “Variances do not, by themselves show why the budget (standard) was not achieved. But they raise questions, provide clues, and direct attention.” “Because there are so many interdependences among, activities, a variance should not lead a manager to jump to conclusions, By themselves, such variances merely raise questions and provide clues. They are attention directors, not answer givers.” Colgate - Darden Business School (Professors Brandt Allen and William Rotch) “There are three important ways in which standard costing systems assist management: 1. The automatic built-in provision of variances helps identify areas that need management's attention. 2. The development of a database of standard costs and quantities supports pricing decisions and helps the overall planning process. 3, The use of standard product costs simplifies inventory accounting.” ‘The Vanderbilt Business School (Professor Germain Boer) “A standard, as defined by the Oxford English Dictionary, is a definite level of excellence or a definite degree of quality, viewed as a preseribed object of endeavor or a measure of what is adequate for some purpose. A standard, as used in management accounting, is a predetermined cost.” “The primary purpose of standards is to measure the difference between what costs are and what costs should be for the purpose of controlling cosis. In a more general sense, the benefits of Petersen Pottery — Note on CMCV standards can be classified as follows: 1 Better control over costs and thus income through the identification of variances ‘between actual and standard costs. 2. More informative income statements which can illustrate the profit impact of ‘variances by showing excess costs as ‘waste and cost savings as gains. 3, Ease and expedition of cost accounting since all inventories can be valued at standard. 4. Basic data are provided for planning and special studies, 5. Other benefits include: ‘a. The planning required to set-up standards. b. Coordination and cooperation is ‘enhanced. by and within all areas. ¢. Standards set total and individual goals.” “Standards should be based on a scientific study cof the quantities of material and units of labor which should be used to produce the product; ‘hat is, they should be engineered standards. The setting of standards is the responsibility of the technical staff of a plant, such as industrial engineers, design engineers, and chemists. Unless the supervisor agroes that a standard is fair, their reaction to variances will be defensive rather than corrective. After the standard quantities are set, they are normally submitted to the accountants for conversion into standard costs.” “Two types of standards have been found acceptable for cost control purposes: (1) the attainable standard, and (2) the perfect standard The former can be used for cost control and. for the development of standard costs. ‘The latter is used only for cost control and may supplement the use of attainable standards. The basic consideration in selecting either or both types is hhow well they will serve the purposes of cost control” “Attainable direct materials standards are based on the type and quantity of material whieh should be used to produce a finished product of specified quality. Allowance is made for normal losses in initial processing, and considering this,Petersen Pottery — Note on CMCV. the yield in quantity of finished or semicfinished product is determined.” “When standard costs are used, allowances are set for spoilage at each operation.” “Under a standard cost system, a standard percentage of total production is set as the quantity of seconds expected ta be produced,” “Brom practical experience, it is evident that perfect operation can never be attained. ‘Thus, perfect standards should be taken as the direction in which attainable standards should move.” Cornell Business School (Professor Ronald Wilton) “Standards should not be determined by the managerial accountant alone. People generally will be more committed to meeting standards if they are allowed to participate in setting them.” “Some managers believe that perfect standards motivate employees to achieve the lowest cost possible. ‘They claim that since the standard is theoretically attainable, employees will have an incentive #0 come as close as possible to achieving it. Other managers and many behavioral scientists disagree. They feel that perfect standards discourage employees, since they are so unlikely to be attained. Moreover, setting unrealistically difficult standards may encourage employees to sacrifice product quality to achieve Tower costs. By skimping on raw-material quality of the attention given manual production tasks, employees may be able to lower the production cost. However, this lower cost may come at the expense of a higher rate of defective ‘units. ‘Thos, the fitm ultimately may incur higher ‘costs than necessary as defective products are rewmed by customers or serapped upon inspeetion.” “Practical standards allow for such occurrences as occasional machine breakdowns and normal amounts of raw-material waste. Attaining a Practical standard keeps employees on their toes, without demanding miracles. Most behavioral theorists believe that practical standards encourage more positive _and productive employee attitudes then do perfect standards.” 215 “Standard costs and variance analysis are usefial in diagnosing organizational performance. These tools help managers to discern 'the story behind the story’ - the details of operations that underlie reported cost and profit numbers. Standard costs, budgets, and variances are also used to evaluate the performance of individuals and depariments. The performance of individuals, relative to standards or budgets, often Is used to help determine salary increases, bonuses, and promotions. When standards and variances affect employee reward strucmres, they can profoundly influence behavior.” “A. standardl-costing system offers. six clear advantages if used properly: 1. Standard costs provide a basis for sensible cost comparisons. It would make no sense to compare budgeted costs at one (planned) activity level with actual costs incurred at a different (actual) activity level. Standard casts enable the managerial accountant to compute the stmdard allowed cost, given actual output, which then serves as a sensible benchmark to compare with the actual cost 2, Computation of standard costs and cost variances enables managers to omploy management by exception. This approach conserves valuable management time. 3. Variances provide a means of performance evaluation and rewards for employees. 4. Since the variances are used in performance evaluation, they provide motivation for employees to adhere to standards. 5. Use of standard costs in product costing results in more stable product costs than if actual production costs were used. Actual costs often fluctuate erratically, whereas standard costs are changed only periodically. 6. A standard-costing system is usually less expensive than an actual costing system. IV. A FINAL THOUGHT Tt is problematic today whether this point of view from section [l—standard costs and variances are useful to management—represents best thinking in the 1990s or merely a 1990s recapitulation of best thinking in the 1960s. Exploring this dilemma is beyond the scope of this note