Lecture 8

Paolo Perego

Management Accounting
IBA 2005-2006
 Program

• Chapter 10: Standard costing and operational

performance measures:
– Cost variance analysis
– Behavioral impact of standard costing
– Criticisms of standard costing
– Operational performance measures
– Balanced Scorecard
• Chapter 11: Flexible budgeting and Overhead
cost variances
 Managing costs

Standard Actual
performance performance
level level

Comparison between
Chapter 10

standard and actual

performance
level

Cost
variance
 Standard costs

Based on carefully
predetermined
amounts:
- Historical data
- Task analysis
Used for planning labor
Standard
Chapter 10

and material requirements.

Costs are
The expected level
of performance:
- difficult, yet attainable targets!

Benchmarks for
measuring performance.
 Management by Exception

Managers focus on quantities and costs

that exceed standards, a practice known as
management by exception.
Chapter 10

Standard
Amount

Direct
Material
Direct
Labor

Type of Product Cost

 Cost Variance Analysis

Standard Cost Variances

Chapter 10

Price Variance Quantity Variance

The difference between The difference between

the actual price and the the actual quantity and
standard price the standard quantity
 A General Model of Cost Variance Analysis

Actual Quantity Actual Quantity Standard Quantity

× × ×
Actual Price Standard Price Standard Price

Price Variance Quantity Variance

Chapter 10

Standard price is the amount that should have been paid for the
resources acquired

Standard quantity is the quantity allowed for the actual good output

AQ(AP - SP) SP(AQ - SQ)

AQ = Actual Quantity SP = Standard Price
AP = Actual Price SQ = Standard Quantity
 Material variances: Example

Hanson Inc. has the following direct material

standard to manufacture one product called Zippy:
1.5 pounds per Zippy at $4.00 per pound
Chapter 7

Last week 1,700 pounds of material were purchased

and used to make 1,000 Zippies.
The material cost a total of $6,630.
 Material variances: Example

Actual Quantity Actual Quantity Standard Quantity

× × ×
Actual Price Standard Price Standard Price

1,700 lbs. 1,700 lbs. 1,500 lbs.

× × ×
Chapter 10

$3.90 per lb. $4.00 per lb. $4.00 per lb.

$6,630 $ 6,800 $6,000

Price variance Quantity variance

$170 favorable $800 unfavorable
 Material variances: Example

Suppose last week 2,800 pounds of material were

purchased at a total cost of $10,920 and 1,700
pounds were used to make 1,000 Zippies.
Chapter 10

How are the variances computed if the amount

purchased differs from the amount used?

Price variance is computed on the entire quantity

purchased
Quantity variance is computed only on the quantity
used.
 Material variances: Example

Actual Quantity Actual Quantity

Purchased Purchased
× ×
Actual Price Standard Price

2,800 lbs. 2,800 lbs.

Chapter 10

× ×
$3.90 per lb. $4.00 per lb.
$10,920 $11,200

Price variance increases

Price variance because quantity purchased
$280 favorable increases.
 Material variances: Example

Actual Quantity
Used Standard Quantity
× ×
Standard Price Standard Price

1,700 lbs. 1,500 lbs.

× ×
Chapter 10

$4.00 per lb. $4.00 per lb.

$6,800 $6,000

Quantity variance is
Quantity variance unchanged because actual
$800 unfavorable and standard quantities
are unchanged
 Labor variances: Example

Hanson Inc. has the following direct labor standard to

manufacture one Zippy:

1.5 standard hours per Zippy at

Chapter 10

$10.00 per direct labor hour

Last week 1,550 direct labor hours were worked at a

total labor cost of $15,810 to make 1,000 Zippies.
 Labor variances: Example

Actual Hours Actual Hours Standard Hours

× × ×
Actual Rate Standard Rate Standard Rate

1,550 hours 1,550 hours 1,500 hours

× × ×
Chapter 10

$10.20 per hour $10.00 per hour $10.00 per hour

$15,810 $15,500 $15,000

Rate (or wage) variance Efficiency variance

$310 unfavorable $500 unfavorable
 Interpreting interaction among variances (1)
• Large variances in either direction indicate performance
is not as planned, due to either poor planning, poor
management, or random fluctuation.

• Unfavorable labor rate (wage) variance:

– could indicate overtime had to be paid
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– workers were not available at lower rates

• Unfavorable labor efficiency variance:
– poor quality materials
– poorly maintained equipment
– poor supervision of workers
• Unfavorable rate (wage) variance with favorable
efficiency variance:
– higher-paid workers performed work more efficiently
 Behavioral impact of standard costing (1)
Evaluating performance evaluation on individual's
variances:
• Emphasizes individual instead of team efforts
• Reluctance to support others

Example: effect of incentive system that insulates

Chapter 10

purchasing department from production department

Purchasing externalities on production:
• Purchase cheaper substandard materials
• Purchase price variance is favorable
• Unusable material results in unfavorable material
quantity variance
Production externalities on purchasing:
• Short lead times on requisitions leads to higher
purchase prices
• Requesting special orders for materials leads to higher
prices
 Behavioral impact of standard costing (2)

Solution to insulation effects:

• Base reward system on both individual and departmental
(team) variances. However: too much weight on teamwork
can lead to shirking (free-rider problem)!
• Mutual monitoring: method where managers or employees
at the same level monitor each other’s performance
Chapter 10

• Example of mutual monitoring: performance evaluation of

both purchasing and production manager depends on both
material price and quantity variances:
– Purchasing manager wants to help production manager
become more efficient in material usage
– Production manager wants to schedule requisitions to
help purchasing manager buy materials at better prices
 A Statistical Approach

Control
Charts
Chapter 10

Display variations in a Distinguish between

process and help to random variations
analyze the variations and variations that
over time. should be investigated.

Provide a warning signal when variations

are beyond a specified level.
 Statistical Control Chart

Warning signals for investigation

•
Favorable Limit •
• • •
•
Chapter 10

Desired Value •
•
Unfavorable Limit
•
1 2 3 4 5 6 7 8 9
Variance Measurements
 Evaluation of Standard Costing

Advantages:
• Sensible Cost Comparisons
• Management by Exception
• Performance Evaluation
• Employee Motivation
Criticisms:
Chapter 10

• Standard costing may be inappropriate in some modern

manufacturing environments
• Undue concern for variances and cost minimization may
lead to lower quality
• Automation reduces labor costs and the significance of
labor variances
• Standard costing may not be applicable in flexible
manufacturing operations with short life-cycle products
 Operational Control Measures

• Raw Material and Scrap Control (e.g. lead

time)
• Inventory Control (e.g. no. of inventory
items)
• Machine Performance (e.g. setup time)
Chapter 10

• Product Quality (e.g. customer satisfaction)

• Productivity (e.g. cost of rework)
• Innovation and Learning (e.g. costs savings
from process improvements)
• Production and Delivery
 Production and Delivery Performance
Measures
Order Production Started Goods
Received Shipped

Process Time + Inspection Time

Wait Time + Move Time + Waiting Time
Chapter 10

Manufacturing Cycle Time

Delivery Cycle Time

Manufacturing
Process Time
Cycle =
Efficiency Manufacturing Cycle Time

See review problems in Appendix!

 Non-financial “Leading” Indicators

Example: Major U.S. Telecommunications Firm (n = 2,156 custom

Year 2 Revenue / Year 1 Revenue
1.24
1.22
1.2
1.18
Chapter 10

1.16
1.14
1.12
1.1
1.08
1.06
1.04
0 20 40 60 80 100
Customer Satisfaction in Year 1
 Non-financial “Leading” Indicators

Example: Valuation Aspects of Customer Satisfaction

MV = -16,775 + 1.73 BVA - 1.77 BVL + 243.2 (ACSI)

Chapter 10

Market Value Book Value Book Value American Customer

of Equity of Assets of Liabilities Satisfaction Index

• Customer satisfaction (i.e. intangible) is not fully reflected in

balance sheet financial accounting measures
• A one-unit change in the ACSI is related to a $243.2 million
change in the market value of equity
 Business Model

A Compelling Place to Work A Compelling Place to Shop A Compelling Place to Invest

Customer
Recommendations

Attitude Service
About the
Job Helpfulness

Return on Assets
Employee Customer
Operating Margin
Behavior Impression
Revenue Growth

Attitude Merchandise
About the
Company Value

Employee Customer
Retention Retention

5 unit increase in DRIVES

1.3 unit increase in DRIVES
0.5% increase in
employee attitude customer impression revenue growth

NOTE: The rectangles represent survey information; the ovals,

hard data.
Adapted from Harvard Business Review, January–February 1998.
 Balanced Scorecard

Strategy

 Measurement is the Financial Perspective

"If we succeed, how will 
language that gives we look to our 
clarity to vague shareholders?”

concepts. Customer Perspective
Chapter 10

"To achieve my vision, 
how must I look to my 
 Measurement is used customers?”

to communicate, not Internal Perspective

to control. "To satisfy my customers, 
at which processes must 
I excel?”

 Strategy can be Organization Learning

described as a series "To achieve my vision, 
how must my organization 
of cause and effect learn and improve?”
relationships
 Balanced Scorecard terminology:
Southwest Airlines Example
Strategy Map

Strategic Theme: Objective Measures: Targets: Initiatives

Operating Efficiency s: How success The level of :
Profits and What the or failure performanc Key action
Financial RONA
strategy is (performanc e or rate of programs
Grow trying to e) against improvemen required to
Fewer planes
Revenues achieve objectives is t needed achieve
Custom
Attract & monitored targets
Retain More
er Customers

On-time Lowest
Service prices

Intern Objectives Measures Targets Initiatives

al
Fast ground •On Ground •30 Minutes •Cycle time
turnaround
•Fast ground
turnaround Time •90% optimizatio
•On-Time n
Learning Departure

Ground crew
alignment
 A Complete Scorecard is a Program for Action
Strategy Map

 Strategic
Strategic Theme:
Theme: Objectives Measures Targets Initiatives
Operations Excellence
Operating Efficiency
Profits and
Financial RONA • Profitability • 30% CAGR
Grow
Fewer planes • Grow Revenues • 20% CAGR
Revenues
Chapter 10

• Fewer planes • 5% CAGR

Attract &
Customer Retain More • More Customers • # Customers • 12% growth •Customer
Customers • Flight is on -time • FAA On Time • Ranked #1 loyalty
• Lowest prices Arrival Rating • Ranked #1 program
On-time Lowest
Service prices • Market Survey • Quality
management
Internal • On Ground Time • 30 Minutes • Cycle time
• Fast ground
Fast ground turnaround • On-Time • 90% optimization
turnaround Departure

Learning • Ground crew • % Ground crew • yr. 1 70% • Ground crew

alignment trained yr. 3 90% training
Ground crew yr. 5 100%
alignment • % Ground crew • ESOP
stockholders
 Make Strategy a Continuous Process

STRATEGY
60% of  85% of management 
organizations don’t  update the  test the  teams spend less 
link strategy &  strategy Strategic Learning  hypotheses than one hour per 
budgets Loop month on strategy 
issues
BALANCED 
SCORECARD

BUDGET

78% of organizations 
lock budgets to an  reporting 92% of 
funding Management Control Loop
annual cycle organizations do 
20% of organizations  not report on lead 
PERFORMANCE
take more than 16 weeks  indicators
to prepare a budget Initiatives & 
Input Programs Output
(Resources) (Results)
 Balanced Scorecard and Strategy

Corporate Strategy Balanced Scorecard Categories

• Achieving good financial results • Financial (revenues, expenses,

margins)
• Delivering for the customer • Strategy (number of customers,
market share)
Chapter 10

• Managing costs strategically • Customer (overall and branch

customer satisfaction)
• Managing risk • Control (audit reports)
• People (teamwork, training,
• Having the right people in the employee satisfaction)
right jobs • Standards (ethics, community
involvement)
 Balanced Scorecard and Incentive Systems

Manager Bonus

Overall Par Score

Chapter 10

Financial Strategy Customer Control People Standards

Par Par Par Par Par Par
Score Score Score Score Score Score

3 Measures 11 Measures 2 Measures 3 Audit 5 Qualitative 5 Qualitative

Judgements Assessments Assessments
 Static and Flexible Budgets

• A static budget is a budget prepared for only

one level of activity.
• It is based on the level of output planned at the
start of the budget period.
• The master budget is an example of a static
Chapter 11

budget.

• A flexible budget is developed using budgeted

revenues or cost amounts based on the level of
output actually achieved in the budget period.

• A key difference between a flexible budget and

a static budget is the use of the actual output
level in the flexible budget
 Static Budget: Example

Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Indirect labor $ 40,000 $ 34,000 $6,000 F
Chapter 11

Indirect materials 30,000 25,500 4,500 F

Power 5,000 3,800 1,200 F
Fixed costs
Depreciation 12,000 12,000 0
Insurance 2,000 2,000 0
Total overhead costs $ 89,000 $ 77,300 $11,700 F

Since cost variances are favorable, have

we done a good job controlling costs?
 Flexible Budgets

The relevant question is . . .

“How much of the favorable cost variance is
due to lower activity, and how much is due to
good cost control?”
To answer the question, we must flex the budget
Chapter 11

to the
actual level of activity.

Central Concept

If you can tell me what your activity was

for the period, I will tell you what your costs and
revenue should have been
 Advantages of Flexible Budgets
• To flex a budget for different activity levels, we must
know how costs behave with changes in activity levels
• Total variable costs change in direct proportion to
changes in activity.
• Total fixed costs remain unchanged within the relevant
range.
Chapter 11

Show revenues and expenses

that should have occurred at the
actual level of activity.

May be prepared for any activity

level in the relevant range.

Reveal variances due to good cost

control or lack of cost control.

Improve performance evaluation

 Flexible Budgets

Variable Total Flexible Budgets

Cost Fixed 8,000 10,000 12,000
Per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Chapter 11

Indirect labor 4.00 $ 32,000 $ 40,000 $ 48,000

Indirect material 3.00 24,000 30,000 36,000
Power 0.50 4,000 5,000 6,000
Total variable cost $ 7.50 $ 60,000 $ 75,000 $ 90,000

Fixed costs
Depreciation $12,000 $ 12,000 $ 12,000 $ 12,000
Insurance 2,000 2,000 2,000 2,000
Total fixed cost $ 14,000 $ 14,000 $ 14,000
Total overhead costs $ 74,000 $ 89,000 $ 104,000
 Flexible Budget Report
at 8,000 actual machine hours

Variable Total
Cost Fixed Flexible Actual
Per Hour Costs Budget Results Variances
Machine hours 8,000 8,000 0
Chapter 11

Variable costs
Indirect labor $ 4.00 $ 32,000 $ 34,000 $ 2,000 U
Indirect material 3.00 24,000 25,500 1,500 U
Power 0.50 4,000 3,800 200 F
Total variable costs $ 7.50 $ 60,000 $ 63,300 $ 3,300 U
Fixed Expenses
Depreciation $12,000 $ 12,000 $ 12,000 0
Insurance 2,000 2,000 2,000 0
Total fixed costs $ 14,000 $ 14,000 0
Total overhead costs $ 74,000 $ 77,300 $ 3,300 U
 Variable Overhead Variances
Actual Flexible Budget Flexible Budget
Variable for Variable for Variable
Overhead Overhead at Overhead at
Incurred Actual Hours Standard Hours
AH × AR AH × SVR SH × SVR
Chapter 11

Spending Variance Efficiency Variance

AH = Actual Hours of Activity

AR = Actual Variable Overhead Rate
SVR = Standard Variable Overhead Rate
SH = Standard Hours Allowed

Spending variance = AH(AR - SVR)

Efficiency variance = SVR(AH - SH)
 Variable Overhead Variances: Example

ColaCo’s actual production for the period required

3,200 standard machine hours. Actual variable
overhead incurred for the period was $6,740.
Actual machine hours worked were 3,300.
Chapter 11

Compute the variable overhead spending and

efficiency variances.
 Variable Overhead Variances: Example

Flexible budget

Total budgeted
=
overhead cost
Chapter 11

Budgeted variable Total

× + Budgeted fixed
overhead cost per activity overhead cost

activity unit units

$2.00 per Total

Total budgeted = machine × machine + $9,000
overhead cost hour hours
 Variable Overhead Variances: Example
Actual Flexible Budget Flexible Budget
Variable for Variable for Variable
Overhead Overhead at Overhead at
Incurred Actual Hours Standard Hours

3,300 hours 3,200 hours

× ×
Chapter 11

$2.00 per hour $2.00 per hour

$6,740 $6,600 $6,400

Spending variance Efficiency variance

$140 unfavorable $200 unfavorable

The $140 unfavorable spending variance and the

$200 unfavorable efficiency variance result in a
$340 unfavorable flexible budget variance.
 Fixed Overhead Variances

Actual Fixed Fixed Fixed

Overhead Overhead Overhead
Incurred Budget Applied
SH × PFOHR
Chapter 11

Budget Volume
Variance Variance

PFOHR = Predetermined Fixed Overhead Rate

SH = Standard Hours Allowed
 Fixed Overhead Variances

Recall that fixed overhead costs are applied to products and

services using a predetermined fixed overhead rate (PFOHR):
Chapter 11

Applied Fixed Overhead = PFOHR × Standard Hours

Budgeted Fixed Overhead

PFOHR =
Planned Activity in Hours
 Fixed Overhead Variances: Example
ColaCo used the following predetermined
fixed overhead rate:
Budgeted Fixed Overhead
PFOHR = Planned Activity in Hours

$9,000
Chapter 11

PFOHR = 3,000 machine hours

PFOHR = $3.00 per machine hour

ColaCo’s actual production required 3,200 standard machine

hours.
Actual fixed overhead was $8,450.

Compute the fixed overhead budget and volume variances.

 Fixed Overhead Variances: Example

Actual Fixed Fixed Fixed

Overhead Overhead Overhead
Incurred Budget Applied
3,200 hours
×
Chapter 11

$3.00 per hour

$8,450 $9,000 $9,600

Budget variance Volume variance

$550 favorable $600 (neither favorable nor
unfavorable)
 Additional variance analyses

See separate set of slides about:

• Marketing sales-mix variances
• Yield and mix variances
• Disaggregation of overhead variances
Chapter 11