368 Pa r t 4 / P l a n n i n g a n d C o n t ro l

Unit Standards
Objective 1 In the preceding scenario, Rosita and Mel both recognized the need to encourage
operating managers to control costs. Cost control often means the difference
Tell how unit between success and failure or between above-average profits and lesser profits.
standards are set Rosita was convinced that cost control meant that her managers had to be cost con-
and why standard scious, and they had to assume responsibility for this important objective. Mel sug-
costing systems are gested that the way to control costs and involve managers is through the use of a
adopted. formal budgetary system.
In Chapter 8, we learned that budgets set standards that are used to control and
evaluate managerial performance. However, budgets are aggregate measures of per-
formance; they identify the revenues and costs in total that an organization should
experience if plans are executed as expected. By comparing the actual costs and
actual revenues with the corresponding budgeted amounts at the same level of activ-
ity, a measure of managerial efficiency emerges.
Although the process just described provides significant information for control,
control can be enhanced by developing standards for unit amounts as well as for
total amounts. In fact, the groundwork for unit standards already exists within the
framework of flexible budgeting. For flexible budgeting to work, the budgeted vari-
able cost per unit of input for each unit of output must be known for every item in
the budget. The budgeted variable input cost per unit of output is a unit standard.
Unit standards are the basis or foundation on which a flexible budget is built.
The unit standard cost for a particular input relies on quantity standards and
price standards. The quantity standards refer to the amount of input that should
Coca-Cola bottlers be used per unit of output. The price standards refer to the
know exactly how amount that should be paid for the quantity of the input to be
much proprietary used. The unit standard cost can be computed by multiplying
Coke syrup and car- these two standards: Quantity standard
Price standard.
bonated water to For example, a soft-drink bottling company may decide that
use for each size five ounces of fructose should be used for every 16-ounce bottle of
bottle. They also cola (the quantity standard), and the price of the fructose should
know standard costs be $0.05 per ounce (the price standard). The standard cost of the
© PR Newswire Coca-Cola Company

per bottle and can fructose per bottle of cola is then $0.25 (5
$0.05). The standard
easily determine just cost per unit of fructose can be used to predict what the total cost
how much a filled of fructose should be as the activity level varies; it then becomes a
bottle should cost. flexible budget formula. Thus, if 10,000 bottles of cola are pro-
duced, the total expected cost of fructose is $2,500 ($0.25

10,000); if 15,000 bottles are produced, the total expected cost of
fructose is $3,750 ($0.25
15,000).

How Standards Are Developed

Historical experience, engineering studies, and input from operating personnel are
three potential sources of quantitative standards. Although historical experience may
provide an initial guideline for setting standards, it should be used with caution.
Often, processes are operating inefficiently; adopting input-output relationships
from the past thus perpetuates these inefficiencies. Engineering studies can deter-
mine the most efficient way to operate and can provide very rigorous guidelines;
however, engineered standards are often too rigorous. They may not be achievable
by operating personnel. Since operating personnel are accountable for meeting the
standards, they should have significant input in setting standards. The same princi-
ples governing participative budgeting pertain to setting unit standards.
Price standards are the joint responsibility of operations, purchasing, person-
nel, and accounting. Operations determines the quality of the inputs required;
 C h a p t e r 9 / S t a n d a rd C o s t i n g : A M a n a g e r i a l C o n t ro l To o l 369

personnel and purchasing have the responsibility of acquiring the input quality
requested at the lowest price. Market forces, trade unions, and other external forces
limit the range of choices for price standards. In setting price standards, purchasing
must consider discounts, freight, and quality; personnel, on the other hand, must
consider payroll taxes, fringe benefits, and qualifications. Accounting is responsible
for recording the price standards and preparing reports that compare actual perform-
ance to the standard.

Types of Standards
Standards are generally classified as either ideal or currently attainable. Ideal stan-
dards demand maximum efficiency and can be achieved only if everything operates
perfectly. No machine breakdowns, slack, or lack of skill (even momentary) are
allowed. Currently attainable standards can be achieved under efficient operating
conditions. Allowance is made for normal breakdowns, interruptions, less than per-
fect skill, and so on. These standards are demanding but achievable.
Of the two types, currently attainable standards offer the most behavioral bene-
fits. If standards are too tight and never achievable, workers become frustrated, and
performance levels decline. However, challenging but achievable standards tend to
extract higher performance levels—particularly when the individuals subject to the
standards have participated in their creation.

Why Standard Cost Systems Are Adopted

Two reasons for adopting a standard cost system are frequently mentioned: to
improve planning and control and to facilitate product costing.

Planning and Control Standard costing systems enhance planning and control
and improve performance measurement. Unit standards are a fundamental require-
ment for a flexible budgeting system, which is a key feature of a meaningful plan-
ning and control system. Budgetary control systems compare actual costs with bud-
geted costs by computing variances, the difference between the actual and planned
costs for the actual level of activity. By developing unit price and quantity standards,
an overall variance can be decomposed into a price variance and a usage or effi-
ciency variance.
By performing this decomposition, a manager has more information. If the vari-
ance is unfavorable, a manager can tell whether it is attributable to discrepancies
between planned prices and actual prices, to discrepancies between planned usage
and actual usage, or to both. Since managers have more control over the usage of
inputs than over their prices, efficiency variances provide specific signals regarding
the need for corrective action and where that action should be focused. Thus, in
principle, the use of efficiency variances enhances operational control. Additionally,
by breaking out the price variance, over which managers potentially have less con-
trol, the system provides an improved measure of managerial efficiency.
The benefits of operational control, however, may not extend to the advanced
manufacturing environment. The use of a standard cost system for operational con-
trol in an advanced manufacturing environment can produce dysfunctional behav-
ior. For example, materials price variance reporting may encourage the purchasing
department to buy in large quantities to take advantage of discounts. Yet, this may
lead to holding significant inventories, something not desired by JIT firms. Thus, the
detailed computation of variances—at least at the operational level—is discouraged
in this new environment. Nonetheless, standards in the advanced manufacturing
environment are still useful for planning, for example, in the creation of bids. Also,
variances may still be computed and presented in reports to higher-level managers
so that the financial dimension can be monitored.
370 Pa r t 4 / P l a n n i n g a n d C o n t ro l

Managers Decide
Standards Help Dairy Trim Delivery Costs
Smith Dairy is a family-owned compliance, and unloading report on speed, shifting,
producer of milk and milk rates. Low unloading rates and temperature in transit;
products that operates in and excessive amounts of and they have reduced idle
Ohio, Indiana, and Kentucky. speed, shifting, idling time, time and lowered fuel costs.
A fleet of refrigerated trucks and braking can significantly The computer record also
delivers its products through- increase delivery costs. Fur- legally replaces the DOT logs
out its sales region. Distribu- thermore, incorrect temper- that drivers formerly com-
tion cost is the second-highest atures can ruin a load of pleted manually (saving about
cost in a dairy, exceeded only goods. $100,000 per year). The sys-
by production cost. Thus, To better monitor deliv- tem has also led to improved
operating standards are set ery performance and improve driver safety by capturing
for such things as truck speed, compliance with operating how vehicles are operated
shifting patterns, idling times, standards, Smith installed on a real-time basis. ■
braking intensity, tempera- onboard computers in each
Source: Jack Mans, “High-Tech Cost Man-
ture in transit, Department of its delivery trucks. These agement,” Dairy Foods (March 2000):
of Transporation (DOT) log computers monitor and 51–53.

Finally, it should be mentioned that there are many firms operating with con-
ventional manufacturing systems. Standard cost systems are widely used. According
to one survey, 87 percent of the firms responding used a standard cost system.1 Fur-
thermore, the survey revealed that significant numbers of the respondents were cal-
culating variances at the operational level. For example, about 40 percent of the
firms using a standard costing system reported labor variances for small work crews
or individual workers.

Product Costing In a standard costing system, costs are assigned to products

using quantity and price standards for all three manufacturing costs: direct materials,
direct labor, and overhead. In contrast, a normal costing system predetermines over-
head costs for the purpose of product costing but assigns direct materials and direct
labor to products by using actual costs. Overhead is assigned using a budgeted rate
and actual activity. At the other end of the cost assignment spectrum, an actual cost-
ing system assigns the actual costs of all three manufacturing inputs to products.
Exhibit 9-1 summarizes these three cost assignment approaches. Standard product
costing has several advantages over normal costing and actual costing. One, of course,
is the greater capacity for control. Standard costing systems also provide readily avail-
able unit cost information that can be used for pricing decisions. This is particularly
helpful for companies that do a significant amount of bidding and that are paid on
a cost-plus basis.
Other simplifications are also possible. For example, if a process-costing system
uses standard costing to assign product costs, there is no need to compute a unit

1 Bruce R. Gaumnitz and Felix P. Kollaritsch, “Manufacturing Variances: Current Practice and Trends,” Journal of
Cost Management (Spring 1991): pp. 58–64. Similar widespread usage is also reported by Carole B. Cheatham
and Leo R. Cheatham, “Redesigning Cost Systems: Is Standard Costing Obsolete?” Accounting Horizons
(December 1996): pp. 23–31. Furthermore, a survey of UK firms reveals that 76% of them use a standard
costing system. See Colin Drury, “Standard Costing: A Technique at Variance with Modern Management,”
Management Accounting (London, November 1999): pp. 56–58.
 C h a p t e r 9 / S t a n d a rd C o s t i n g : A M a n a g e r i a l C o n t ro l To o l 371

Manufacturing Costs
Direct Materials Direct Labor Overhead
Actual costing system Actual Actual Actual
Normal costing system Actual Actual Budgeted
Standard costing system Standard Standard Standard

Exhibit 9-1 Cost Assignment Approaches

cost for each equivalent unit cost category. A standard unit cost would exist for
each category.2 Additionally, there is no need to distinguish between the FIFO and
weighted average methods of accounting for beginning inventory costs. Usually, a
standard process-costing system will follow the equivalent unit calculation of the
FIFO approach. That is, current equivalent units of work are calculated. By calculat-
ing current equivalent units of work, current actual production costs can be com-
pared with standard costs for control purposes.

Standard Product Costs

Standard costs can also be used in service organizations. The IRS, for example, could Objective 2
set standard processing times for different categories of returns. If the standard pro-
cessing time is three minutes for a 1040EZ and the standard price of labor is $9 per State the purpose
hour, then the standard cost of processing a 1040EZ is $0.45 [$9
(3/60)]. Other of a standard cost
examples exist. The federal government is using a standard costing system for reim- sheet.
bursing Medicare costs. Based on several studies, illnesses have been classified into
diagnostic related groups (DRGs), and the hospital costs that should be incurred for
an average case identified. (The costs include patient days, food, medicine, supplies,
use of equipment, and so on.) The government pays the hospital the standard cost
for the DRG. If the cost of the patient’s treatment is greater than the DRG allows, the
hospital suffers a loss. If the cost of the patient’s treatment is less than the DRG
reimbursement, the hospital gains. On average, the hospital supposedly breaks even.
Although service organizations can and do make use of standard costing, applica-
tions are more common in manufacturing organizations. Furthermore, the concepts
are more easily illustrated in manufacturing settings.
In manufacturing firms, the standard cost per unit is the sum of the standard
costs for direct materials, direct labor, and overhead. The standard cost sheet pro-
vides the details underlying the standard unit cost. To illustrate, let’s develop a stan-
dard cost sheet for a 16-ounce bag of Bluechitos, the corn chips produced by Blue-
Corn Foods, Inc. The production of the corn chips begins with steaming and soaking
corn kernels overnight in a lime solution. This process softens the kernels so that
they can be shaped into a sheet of dough. The dough is then cut into small triangu-
lar chips. Next, the chips are toasted in an oven and dropped into a deep fryer. After
cooking, the chips pass under a salting device and are inspected for quality. Substan-
dard chips are sorted and discarded; the chips passing inspection are bagged by a
packaging machine. The bags of chips are manually packed into boxes for shipping.
Four materials are used to process corn chips: blue corn, lime, cooking oil, and
salt. The package in which the chips are placed is also classified as a direct material.
The Bluechitos line has two types of direct laborers: machine operators and inspec-
tors (or sorters). Variable overhead is made up of three costs: gas, electricity, and

2 If you have not yet read Chapter 6 on process costing, the example illustrating the simplifications made pos-
sible by standard costing will not be as meaningful. However, the point is still relevant. Standard costing can
bring useful computational savings.
372 Pa r t 4 / P l a n n i n g a n d C o n t ro l

Description Standard Standard Standard

Price Usage Cost* Subtotal
Direct materials:
Blue corn $ 0.006 18 oz. $0.108
Cooking oil 0.031 2 oz. 0.062
Salt 0.005 1 oz. 0.005
Lime 0.400 0.01 oz. 0.004
Bags 0.044 1 bag 0.044
Total direct materials $0.223
Direct labor:
Inspectors 7.000 0.0070 hr. $0.049
Machine operators 10.000 0.0008 hr. 0.008
Total direct labor 0.057
Overhead:
Variable overhead 3.850 0.0078 hr. $0.030
Fixed overhead 32.050 0.0078 hr. 0.250**
Total overhead 0.280
Total standard unit cost $0.560

*Calculated by multiplying price times usage.

**Rounded

Exhibit 9-2 Standard Cost Sheet for Bluechitos

water. Both variable and fixed overhead are applied using direct labor hours. The
standard cost sheet is given in Exhibit 9-2. Note that it should cost $0.56 to produce
a 16-ounce bag of blue-corn chips. Also, notice that the company uses 18 ounces of
corn to produce a 16-ounce bag of chips. There are two reasons for this. First, some
chips are discarded during the inspection process. The company plans on a normal
amount of waste. Second, the company wants to have more than 16 ounces in each
bag to increase customer satisfaction with its product and avoid any further prob-
lems with fair packaging laws.
Exhibit 9-2 also reveals other important insights. The standard usage for variable
and fixed overhead is tied to the direct labor standards. For variable overhead, the
rate is $3.85 per direct labor hour. Since one bag of corn chips uses 0.0078 direct
labor hour, the variable overhead cost assigned to a bag of corn chips is $0.03
($3.85
0.0078). For fixed overhead, the rate is $32.05 per direct labor hour, mak-
ing the fixed overhead cost per bag of corn chips $0.25 ($32.05
0.0078). Nearly
half of the cost of production is fixed, indicating a capital-intensive production
effort. Indeed, much of the operation is mechanized.
The standard cost sheet also reveals the quantity of each input that should be
used to produce one unit of output. The unit quantity standards can be used to
compute the total amount of inputs allowed for the actual output. This computation
is an essential component in computing efficiency variances. A manager should be
able to compute the standard quantity of materials allowed (SQ) and the stan-
dard hours allowed (SH) for the actual output. This computation must be done
for every class of direct material and every class of direct labor. Assume, for example,
that 100,000 bags of corn chips are produced during the first week of March. How
much blue corn should have been used for the actual output of 100,000 bags? The
unit quantity standard is 18 ounces of blue corn per bag (see Exhibit 9-2). For
100,000 bags, the standard quantity of blue corn allowed is computed as follows:
SQ  Unit quantity standard
Actual output
 18
100,000
 1,800,000 ounces
 C h a p t e r 9 / S t a n d a rd C o s t i n g : A M a n a g e r i a l C o n t ro l To o l 373

The computation of standard direct labor hours allowed can be illustrated using
machine operators. From Exhibit 9-2, we see that the unit quantity standard is
0.0008 hour per bag produced. Thus, if 100,000 bags are produced, the standard
hours allowed are as follows:
SH  Unit labor standard
Actual output
 0.0008
100,000
 80 direct labor hours

Variance Analysis: General Description

A flexible budget can be used to identify the costs that should have been incurred Objective 3
for the actual level of activity. This figure is obtained by multiplying the amount of
input allowed for the actual output by the standard unit price. Letting SP be the Describe the basic
standard unit price of an input and SQ the standard quantity of inputs allowed for concepts underlying
the actual output, the planned or budgeted input cost is SP
SQ. The actual input variance analysis,
cost is AP
AQ, where AP is the actual price per unit of the input, and AQ is the and explain when
actual quantity of input used. variances should be
investigated.

Price and Efficiency Variances

The total budget variance is simply the difference between the actual cost of the
input and its planned cost. For simplicity, we will refer to the total budget variance
as the total variance:
Total variance  (AP
AQ)  (SP
SQ)
In a standard costing system, the total variance is broken down into price and
usage variances. Price (rate) variance is the difference between the actual and stan-
dard unit price of an input multiplied by the number of inputs used: (AP  SP)AQ.
Usage (efficiency) variance is the difference between the actual and standard
quantity of inputs multiplied by the standard unit price of the input: (AQ  SQ)SP.
It is easy to show that the total variance is the sum of price and usage variances:
Total variance  Price variance  Usage variance
 (AP  SP)AQ  (AQ  SQ)SP
 [(AP
AQ)  (SP
AQ)]  [(SP
AQ)  (SP
SQ)]
 (AP
AQ)  (SP
AQ)  (SP
AQ)  (SP
SQ)
 (AP
AQ)  (SP
SQ)
Exhibit 9-3 presents a three-pronged diagram that describes this process. Usually,
the total variance is divided into price and efficiency components for direct materials
and direct labor. The treatment of overhead is discussed later in the chapter.
Unfavorable (U) variances occur whenever actual prices or usage of inputs are
greater than standard prices or usage. When the opposite occurs, favorable (F) vari-
ances are obtained. Favorable and unfavorable variances are not equivalent to good
and bad variances. The terms merely indicate the relationship of the actual prices or
quantities to the standard prices and quantities. Whether or not the variances are
good or bad depends on why they occurred. Determining why requires managers to
do some investigation.

The Decision to Investigate

Rarely will actual performance exactly meet the established standards, and management
does not expect it to. Random variations around the standard are expected. Because
of this, management should have in mind an acceptable range of performance. When