Using Cost Data for Control

A control system is made of three sub-components. The first component is the “standard level” that experts determine before the operations begin. The second part is “actual level” that depends on measurement after the end of the operations; and, the last level is “comparison of standard and actual levels”.

In a budgetary control system, the standards are set, at first. These standards represent what it should cost the company to produce one unit of finished goods. Then, the standards are multiplied with the production volume to determine the total budgeted production cost for the upcoming period. When the period ends, the actual production cost is measured and deviations from the budgeted costs are determined.

Managers use these deviations to evaluate the performance and to take corrective actions, when necessary. However, in order to use their time more effectively, managers separate the deviations as significant and insignificant deviations and follow up only the material ones. This is called “management by exception” (Edmonds et al., 2000: 329). 

Generally, managers use two methods for setting the cost standards: historical data analysis and task analysis.

If the company has enough experience at producing the product, analysis of historical data can be a good way to determine the standards for the upcoming period.

In task analysis by analyzing the tasks during the production (with the help of time and
motion studies) the standards, such as how much direct materials should be included in the product or how many hours of labor and machine use is required for producing each unit, are set. 

Some companies prefer to use a combination of both, given the company has enough experience producing the product.

There are several types of standards that can be classified from different perspectives, such as:
a. the level of difficulty,
b. updating frequency,
c. subject of standards,
d. level of participation to the standard-setting process

Managers apply the standard costs, instead of the actual (realized) costs, for calculating the costs of their products. Using the standards for product cost calculation, at the same time, means using the standards for financial reporting purposes. If the standard costs are used instead of the actual costs, financial reports need adjustments at the end of the period, in order to reflect the actual results. This adjustment is done by using the variance accounts that represent the deviations from the actual results. The accounting system, in which standard costs and associated variances are recorded in the formal accounting records is called the “standard costing”.

Use of standard costing makes it easier to compare the actual results with budgeted results, by providing the opportunity to determine a new target that is adjusted for the actual output level, instead of a fixed level of production. The variances also provide benchmark points for the managers to evaluate the performance. As a result of the evaluations, employees may be punished or rewarded; both motivate them to meet the standards.

Next to planning, correction, and performance evaluation benefits, using the standard costs instead of the actual costs helps management with pricing decisions, too. Standard costing is also better than the actual costing in terms of timeliness of cost data to use in pricing decisions. 

The opponents of standard costing suggest that the variances are calculated after the company incurred the costs and revenues; therefore, it becomes too late to guide the managers. In addition, traditional standard costing systems are blamed for focusing too much on the efficiency of direct labor, which loses its relative value in modern production systems.

Shortening product-life-cycles also shortens the  duration of standards’ validity. Thus, new standard development is required each time a new product is launched, again for a short period of time. Standard costs are also suggested not to include all factors, such as the delivery and storage cost for direct materials. They also tend to focus only on cost minimization, rather than improving the product quality.

As an alternative to other systems, standard costing is appropriate for both planning and pricing decisions because the use of predetermined costs and rates allows management to plan the capacity and determine an appropriate price for the product.

A standard cost sheet is a record that specifies the details of standard costs (including both price and quantity) for all manufacturing factors needed for producing one unit.

The standard cost for direct materials has three facets as quality, quantity, and price. The first step is to specify the desired quality of direct materials. The quality of direct materials determines the quality of the product and changes the production schedules to some extent. 

As the desired quality is determined, managerial accountants work with industrial engineers and production department in order to determine the required quantity of direct materials for each unit of output.

The last step is determining the standard purchase price for direct materials. Accounting department works with the purchasing department and depending on the negotiations with suppliers, the standard price per unit of direct materials is determined.

In order to determine the standards for direct labor cost, industrial engineers, production personnel, labor union representatives and managerial accountants work together. They consider the transactions and qualifications required for the work and the condition of equipment to use; and set a standard time of labor
work.

The manufacturing overhead costs are indirect
costs; therefore, quantity does not represent direct
consumption of a resource. Instead, the quantity
standards are set in terms of allocation bases,
separate for each indirect cost pool. Cause-and-effect relationship and
the level of effect on expenses are the fundamental
criterion for selecting the bases.

Standard costing applies the standards for all components of manufacturing in the calculation of product cost. The accounts used to represent the cost flows are the same for all systems; the difference is the bases considered for costing the components.

Standard costing uses variance accounts specific to each component of manufacturing. Favorable variances are credited and unfavorable variances are debited on the accounts. These variances are either disposed directly to COGS or prorated between inventory accounts and COGS at the end of period.

In business life, control refers to the set of procedures, tools, and systems that are used by companies to ensure that progress is being made toward accomplishing the goals and objectives (Blocher, 2010: 591).
If these goals are related to short-term operational performance, the term operational control is preferred for describing the procedures and processes. Operational controls are subdivided into financial and nonfinancial control dimensions.

By comparing the actual results with the budgeted targets, the deviations
(variances) are calculated. Considering the amounts and directions of variances (either favorable ,those that increase operating income, or unfavorable ,those that decrease it), management takes actions either to keep the ongoing processes or correct the inefficient operations. 

Flexible budget is the budget that adjusts the revenues and expenses according to actual sales volume. The master budget is useful for planning and coordination purposes; however, its static nature limits its usefulness for performance evaluation. Operating conditions usually do not match the conditions that management expects or forecasts at the time budgets are prepared. In order to evaluate the short-term financial performance, companies at first revise the static budgets for the actual sales volume.

Direct materials cost in the flexible budget states the standard amount of direct materials that should be used for producing the actual volume of outputs. By comparing this cost with the actual cost, direct materials flexible budget variance is calculated. There are two possible reasons for this variance; purchase price and quantity. When the actual unit price that the company has paid for direct materials differs from the standard unit price, Direct Materials Price Variance appears. On the other hand, when the company consumes direct materials at different amounts than the standards require, in this case, “Direct Materials Efficiency Variance” is generated.

Direct labor flexible-budget variance represents the difference between the actual labor cost and standard labor cost needed for the actual output. Similar to direct materials variances, direct labor variances have two components as; (i) direct labor price (rate) variance and (ii) direct labor efficiency (quantity) variance. 

Direct labor price variance arises when the wage rate that a company pays is different from the standard rates predetermined before the beginning of the period.

Direct labor efficiency variance occurs when the total direct labor hours deviate from standard direct labor hours for the actual production level.

Overhead is different from direct costs in that the resources cannot be traced to cost objects in an economically feasible way because the indirect manufacturing costs do not have a homogenous structure. 

Indirect materials, indirect labor, power, utilities, etc. are examples of overhead costs; and, in order to determine product cost, these overhead components should be allocated by using a common basis. The need for allocation brings together the necessity of considering the use of allocation bases in terms of both rate and quantity.

Variable overhead spending variance measures the effect of differences between actual and standard rates; in other words, actual and standard costs per unit of the allocation  base. To calculate the actual (standard) rate, actual (standard) overhead cost is divided by the actual (standard) number of direct labor hours.

Variable overhead efficiency variance measures the change in variable overhead costs with respect to the use of allocation base chosen. It is calculated by subtracting the standard quantity of allocation base from the actual quantity of allocation base and multiplying the result by the standard rate per unit of allocation base.

Analysis of fixed overhead is different than analyzing the other costs because the fixed overhead cost does not change with the production volume. The amount of fixed overhead costs in the flexible budget equals the fixed overhead in the
static budget.

The difference between the actual and budgeted fixed overhead costs is called the Fixed Overhead Spending Variance. In other words, the difference between what the company plans to incur and what the company incurs during the period is the spending variance.

The variance that helps the control of fixed costs in terms of capacity utilization is called the production volume variance. Production volume variance is calculated as the difference between the fixed overhead cost budgeted for planned production and the fixed overhead cost allocated to actual production. In summary, the variance provides information about unused capacity investment.

The calculation of production volume variance is represented below:
Fixed OH Production Volume Variance = Budgeted Fixed OH - Allocated Fixed OH
Allocated Fixed OH = Rate per hour x Standard number of hours needed for actual output