PART 7

FLEXIBLE BUDGET AND

STANDARD COSTS

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-1
CONTENTS
Chapter 10:
Standard costs and their computation and
uses
Variances analysis
Chapter 11:
Variances analysis (Cont.)
How standard cost information is useful
for management by exception

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-2
 Chapter 10

Standard costs for control:

direct material and direct
labour

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-3
 Chapter 10 - Outline
Controlling costs
Setting standards
Calculating standard cost variances
Investigating significant variances
Cost control through assigning
responsibility
Standard costing and behaviour
Standard costs for product costing
Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-4
 Controlling costs
Businesses are in control when
operations plan and achieve objectives
Control systems provide regular
information to assist in control
Necessary requirements for control
A predetermined performance level
A measure of actual performance
A comparison between standard
performance and actual performance (cont.)

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-5
Control systems: a thermostat
If the actual temperature rises above the preset or standard
temperature, the thermostat activates the cooling mechanism
to bring the temperature back to 22C

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-6
 Standard costing
Standard costing is a part of the
budgetary control system
A predetermined or standard cost is
developed
The actual cost incurred in the product
process is measured
The actual cost is compared to the
standard cost to determine a standard
cost variance

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-7
 Standard cost variances
Used to evaluate actual performance
and control costs
Standard costs can be developed for
direct material, direct labour and
overheads
When cost variances are significant the
cause of the variance must be
investigated

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-8
 Setting standards
A variety of methods may be used to
set cost standards
Analysis of historical data
Engineering methods
Participation by managers/employees
in standard setting may lead to greater
commitment to meeting those
standards

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-9
Analysis of historical data
May provide a good basis for predicting
future costs
Often need to adjust predictions to
reflect price or technological changes
Minor changes can make historical
costs irrelevant
Historical costs may embody past
inefficiencies

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-10
 Engineering methods
The focus is on what the product should
cost in the future
How much material should be required and
how much direct labour should be used
Time and motion studies can determine
how long each step in a production
process should take
In practice, both historical cost analysis
and engineering methods may be used
together
Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-11
 Perfection standards
Reflect minimum attainable costs under
nearly perfect operating conditions
Assumes peak efficiency, the lowest material
and labour prices, the use of the best quality
materials and no production disruptions
Motivational impact?
Motivation to achieve lowest cost possible
May discourage employees from working
hard as standards unlikely to be achieved
May encourage employees to sacrifice
product quality to achieve low costs
Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-12
 Practical standards
Practical standards are the minimum
attainable costs under normal operating
conditions
allowances made for downtime and wastage
Motivational impact?
May encourage more positive attitudes
towards targets
May encourage inefficiency and waste
Can build continuous improvement into
standards to make them more demanding
Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-13
 Benchmarking of costs
May involve:
Identifying companies that have the best
cost performance
Assessing their level of costs
Identifying the cost performance gap
Identifies areas needing to improve cost
performance
Cost standards may be formulated to
achieve external performance standards
Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-14
 Direct material standards
Standard material quantity
The total amount of direct material
required to produce one unit of product
Standard material price
The total delivered cost of direct material
required to produce one unit of product
Based on ordering a certain quality of
material in specific order quantities from a
specified supplier

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-15
 Direct labour standards
Standard direct labour
The number of labour hours normally
needed to manufacture one unit of product
Standard labour rate
The total hourly cost of wages, including
on-costs
On-costs are extra salary-related costs that all
companies have to pay and are usually treated
as part of the cost of labour
(cont.)

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-16
 Direct labour standards
Actual costs for moleskin pants
R.M. Williams, September

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-17
 Standard costs given
actual output

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-18
 Direct material variances
Direct material price variance
A measure of the effect on cost of
purchasing at a price that is different
from standard
= PQ(AP SP)
where PQ = quantity purchased
AP = actual price
SP = standard price
(cont.)

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-19
Direct material variances (cont.)
Direct material quantity variance
A measure of the effect on cost of using a
different quantity of material in production
compared with the standard quantity that
should have been used
= SP(AQ SQ)
where SP = standard price
AQ = actual quantity used
SQ = standard quantity used, given
actual output
(cont.)

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-20
Direct material variances (cont.)
Direct material price variance can be
calculated using the quantity of
materials used in production (AQ)
rather than the quantity of materials
purchased (PQ)
= AQ(AP SP)
where AQ = actual quantity of material
used in production
AP = actual price
(cont.)
SP = standard price
Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-21
 Direct material price and quantity
variances, R.M. Williams

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-22
 Direct labour variances
Direct labour rate variance
A measure of the effect on cost of paying a
different labour rate, compared with
standard
= AH(AR SR)
where AH = actual hours used
AR = actual rate per hour
SR = standard rate per hour
(cont.)

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-23
 Direct labour variances (cont.)
Direct labour efficiency variance
The effect on cost of using a different
number of direct labour hours, compared
with the standard hours that should have
been used for the actual production output
= SR(AH SH)
where AH = actual hours used
SH = standard hours allowed, given
actual output
SR = standard rate per hour
(cont.)

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-24
 Direct labour rate and efficiency
variances, R.M. Williams

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-25
 Investigating significant
variances
Management by exception
Only significant cost variances are
reported and investigated
Which variances are significant?
Size of variance
Recurring variances
Trends
Controllability of the variance (cont.)

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-26
 Investigating significant
variances (cont.)
Favourable and unfavourable variances
warrant similar investigation
May reveal efficiencies and new improved
practices
May mean that the standard is too loose
Investigating variances may include
Talking with managers and employees
Writing reports to explain variances and
recommend corrective actions
Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-27
 A statistical approach to
variance investigation
There may be many reasons for standard
cost variances
May be caused by random fluctuations
which may not require correction
Statistical control charts plot standard
cost variances across time and compare
them with a critical value

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-28
Statistical control chart for direct
labour efficiency variance,
R.M. Williams, January to June

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-29
 Costs and benefits of
investigation
Costs include
Time spent investigating the problem
Disruption to the production process
Cost of implementing corrective actions
Benefits may include
Reduced costs if the cause of the variance is
eliminated
Improved work practices
Management skills and experience allows
managers to weigh up these considerations
Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-30
 Cost control through
assigning responsibility
Cost control is accomplished through the
efforts of individual managers and employees
Managers are held responsible for achieving
certain cost standards
Interactions between variances make it
difficult to assign responsibility
Not all favourable variances are desirable
Unfavourable variances do not always indicate a
problem
Source of the variance may lie elsewhere

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-31
Standard costing and behaviour
Standards should not be set by
management accountants alone
Not experts in areas such as material
usage and labour rates
Managers may have better working
knowledge
Managers controlling processes should
participate in settings standards
Behavioural response to incentives
Negative and positive responses
Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-32
 Standard costs for product costing
Standard costing system
All inventories are recorded at standard
cost
Variances are closed off at the end of
the accounting period
To cost of goods sold expense
Prorate variances between work in
process inventory, finished goods
inventory and cost of goods sold

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-33
 Flow of costs through
manufacturing accounts

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-34
 Summary
Standard costing systems can be
used for cost control
Cost variances can be calculated for
direct material and direct labour
Decision rules will guide which cost
variances need to be investigated
Variance reporting can form part of a
responsibility accounting system
Standard costs can be used for
external reporting purposes
Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-35
Exe 10.23

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 10-36