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MANAGEMENT ACCOUNTING: CONCEPTS AND TECHNIQUES

 

By Dennis Caplan

 

PART 3: PRODUCT COSTING AND COST ALLOCATIONS

 

CHAPTER 10:  STANDARD COSTING

 

Chapter Contents:

-                     Introduction

-                     Standard Costs

-                     Example of a Standard Cost Sheet

-                     Standard Costing Systems

-                     Standard Costing Systems and Flexible Budgeting

-                     ZFN Apparel Company, Standard Costing Example

-                     Reasons for Using a Standard Costing System

-                     Summary of Actual Costing, Normal Costing and Standard Costing

 

Introduction:

If you were to design a cost accounting system with no accounting education other than financial accounting courses, you would probably design an accounting system that collects, summarizes, and reports actual costs. This approach would be consistent with the implicit assumption throughout every financial accounting course that when financial statements report historical cost data, such as would normally be the case for cost-of-goods-sold and ending inventory, that the information reported represents actual costs. Therefore, it comes as a surprise to most students that the initial journal entries to record the production and movement of inventory in the costing systems of most manufacturing firms are not based on actual costs at all, but rather are based on budgeted per-unit costs.

 

In most manufacturing firms, the initial journal entries to debit work-in-process, finished goods and cost-of-goods-sold are based on the actual quantity of output produced, multiplied by budgeted data about the inputs necessary to produce those outputs, and the budgeted costs of those inputs. Then, at the end of the month (or possibly quarterly), an “adjusting” or “closing” entry is made to record in the inventory accounts the difference between actual costs incurred, and the budgeted information that has formed the basis for the journal entries during the month. The nature of this adjusting entry depends on the materiality of the amounts involved. If the differences between actual costs and budgeted costs are small, this adjusting entry might be made in an expedient manner, involving only cost-of-goods-sold, but if the differences are large, the adjusting entry might also involve work-in-process and finished goods inventory accounts.

 

The accounting system described above is called a standard costing system, and it is widely-used by companies in the manufacturing sector of the economy. This chapter describes standard costing systems, and explains why companies use them. But first we discuss a related concept, standard costs, which constitutes an important component of standard costing systems.    

 

Standard Costs:

A standard, as the term is usually used in management accounting, is a budgeted amount for a single unit of output. A standard cost for one unit of output is the budgeted production cost for that unit. Standard costs are calculated using engineering estimates of standard quantities of inputs, and budgeted prices of those inputs. For example, for an apparel manufacturer, standard quantities of inputs are required yards of fabric per jean and required hours of sewing operator labor per jean. Budgeted prices for those inputs are the budgeted cost per yard of fabric and the budgeted labor wage rate.

 

Standard quantities of inputs can be established based on ideal performance, or on expected performance, but are usually based on efficient and attainable performance. Research in psychology has determined that most people will exert the greatest effort when goals are somewhat difficult to attain, but not extremely difficult. If goals are easily attained, managers and employees might not work as hard as they would if goals are challenging. But also, if goals appear out of reach, managers and employees might resign themselves to falling short of the goal, and might not work as hard as they otherwise would. For this reason, standards are often established based on efficient and attainable performance. 

 

Hence, a standard is a type of budgeted number; one characterized by a certain amount of rigor in its determination, and by its ability to motivate managers and employees to work towards the company’s objectives for production efficiency and cost control.

 

There is an important distinction between standard costs and a standard costing system. Standard costs are a component in a standard costing system. However, even companies that do not use standard costing systems can utilize standards for budgeting, planning, and variance analysis.

 

Example of a Standard Cost Sheet:

The following example shows a standard cost sheet for a deluxe widget. It is a fictional example, yet provides a realistic picture of the level of detail involved in setting standard costs. Many manufacturing companies would have a standard cost sheet for each product, and would revise these cost sheets periodically, perhaps annually or once every three to five years, to incorporate changes in prices of inputs and manufacturing processes.


 

 

Inter-Office Memorandum

WIDGETS UNLIMITED, LTD.

 

 

To:                  Max David                                                                                                                                                                                    Date:   July 8

From               Iris Brenner

Project:           Deluxe Widget

 

Attached is a sample of a cost model I did for the Deluxe Widget. As discussed at the last meeting, we probably want to use a model such as this to keep track of our standard costs as they change over time. We may want to have separate models for the motor and the housing. Please review the model and let me know of any changes that you feel would be helpful.

 

 

Distribution:

Hayden Dubinski

Louis DuPuis

Claire Brown

Thea Kimber

Allison Kirstukas

Zoe Pritchard

 


 

Segments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Lining:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sleeve:

 

 

 

 

 

 

 

 

 

 

Closure:

 

 

 

 

 

 

 

 

Ring:

 

 

 

 

 

 

 

 

 

 

 

 

 

Core:

 

 

 

 

 

 

 

Top:

 

 

 

 

 

 

Window:

 

 

 

 

 

Misc. Labor:

As Cast

 

 

 

 

 

Machining

 

Coating

 

 

Total for 6 segments

(based on qty of 500)

 

Materials:

 

 

 

 

 

Molding:

 

 

 

 

 

 

Total for 6 Linings

 

 

Material (tubing)

 

 

Machining

 

Coating

 

 

Total for 6 Sleeves

For 6 Linings & Sleeves

 

Material

 

 

Machining

 

Total: 6 Closures

 

 

 

Material:

 

 

 

 

 

Molding:

 

 

 

 

 

Total for Ring

 

Material

 

 

Machining

 

Total for Core

(Engineering Estimate)

 

Top from Vendor

 

Anodize

 

 

Total for Top

 

Window from Vendor

 

Anodize

 

Total for Window

 

Assembly and Balancing

 

Spin

 

Total for Misc. Labor

 

 

100 pieces

500 pieces

1000 pieces

material overhead @

 

 

 

material overhead @

 

 

 

 

 

 

Resin

Adhesive

Prepreg

material overhead @

 

 

Winding

Tool Assembly

Injection

Decouple

Demold

 

 

 

 

 

material overhead @

 

 

 

 

material overhead @

 

 

 

 

 

material overhead @

 

 

 

 

 

 

 

Carbon

Resin

Prepreg

material overhead @

 

 

Winding

Tool Assembly

Resin Transfer

Demolding

 

 

 

 

 

material overhead @

 

 

 

 

 

 

 

material overhead @

 

material overhead @

 

 

 

 

material overhead @

 

material overhead @

 

5.00 ea

4.00 ea.

3.00 ea

22%

 

0.1   hrs @

 

10%

 

 

 

 

 

 

 

 

 

22%

 

 

0.20 hrs @

0.15 hrs @

0.10 hrs @

0.01 hrs @

0.25 hrs @

0.71 hrs

 

 

 

 

22%

 

0.25 hrs @

 

 

10%

 

 

 

 

 

22%

 

0.16 hrs @

 

 

 

 

 

 

 

 

22%

 

 

0.30 hrs @

0.20 hrs @

0.10 hrs @

0.10 hrs @

0.70 hrs @

 

 

 

 

22%

 

0.0    hrs @

 

 

 

 

 

22%

 

10%

 

 

 

 

22%

 

10%

 

 

0.75 hrs @

 

0.50 hrs @

 

 

 

 

 

 

92.40

 

 

 

 

 

 

 

25.00

1.00

0.75

2.00

6.33

35.08

 

85.00

85.00

85.00

85.00

85.00

 

 

 

 

 

 

 

92.40

 

 

 

 

 

 

 

 

 

 

92.40

 

 

 

 

 

 

 

 

 

 

 

85.00

85.00

85.00

85.00

 

 

 

 

 

 

 

92.40

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

92.40

 

92.40

 

 

 

4.00

 

0.88

 

9.24

 

1.00

0.10

 

 

 

 

 

 

 

 

 

 

 

17.00

12.75

8.50

0.85

21.25

60.35

 

 

 

5.00

1.10

 

23.10

 

2.00

0.20

 

 

 

 

9.00

1.98

 

14.48

 

 

 

 

 

100.00

4.00

9.00

24.86

137.86

 

25.50

17.00

8.50

8.50

59.50

 

 

 

0.00

0.00

 

0.00

 

 

 

 

15.00

3.30

5.00

0.50

 

 

 

80.00

17.60

8.00

0.80

 

 

69.30

 

46.20

 

 

 

 

 

 

 

 

 

 

 

91.32

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

572.55

 

 

 

 

 

 

 

 

 

 

188.40

760.95

 

 

 

 

 

 

152.76

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

197.36

 

 

 

 

 

 

200.00

 

 

 

 

 

 

 

23.80

 

 

 

 

 

106.40

 

 

 

 

 

115.50

Total Deluxe Widget Standard Cost (based on quantity of 500)

 

Total Deluxe Widget Standard Cost w/o Sleeves and Closures

$1,648.08

 

$1,306.93

 


Standard Costing Systems:

A standard costing system initially records the cost of production at standard. Units of inventory flow through the inventory accounts (from work-in-process to finished goods to cost of goods sold) at their per-unit standard cost. When actual costs become known, adjusting entries are made that restate each account balance from standard to actual (or to approximate such a restatement). The components of this adjusting entry provide information about the company’s performance for the period, particularly with regard to production efficiency and cost control.

 

 

Standard Costing Systems and Flexible Budgeting:

There is an important connection between flexible budgeting, which was discussed in Chapter 5, and standard costing. In fact, a standard costing system tracks inventory during the period at the flexible budget amount. Recall that the flexible budget is the budgeted per-unit cost multiplied by the actual number of units. Hence, a standard costing system answers the question: what would the income statement and balance sheet look like, if costs and per-unit input requirements were exactly as planned, given the actual output achieved (units made and units sold). 

 

Given the point made in the previous paragraph, it follows that the adjustment made at period-end to restate the inventory accounts for the difference between the standard cost account balance and the actual cost account balance constitutes the difference between the flexible budget amount and actual costs. For direct costs, such as materials and labor, this adjusting entry represents the sum of the price (or labor wage rate) variance and the efficiency (or quantity) variance. For overhead costs, this adjusting entry represents misapplied overhead. For variable overhead, misapplied overhead consists of the sum of the spending variance and the efficiency variance. For fixed overhead, misapplied overhead consists of the sum of the spending variance and the volume variance. These overhead variances are discussed in Chapter 17.

 

Hence, standard costing systems track inventory at flexible budget amounts during the period, and post adjusting entries at the end of the period that provide variance information that managers use for performance evaluation and control.

 

 

ZFN Apparel Company, Standard Costing Example:

We continue with the ZFN example from the previous two chapters. The ZFN apparel company in Albuquerque, New Mexico makes jeans and premium chinos. Each product line has its own assembly line on the factory floor. The following table shows actual and budgeted information for the year. There was no beginning or ending work-in-process.


 

 

Budgeted Information

Actual

Results

Units produced

  Jeans

  Chinos

    Total

 

Direct Costs:

Jeans:

  Materials (denim)

    Price per yard

    Yards per jean

      Material cost per jean

 

  Direct labor

    Wage rate

    Hours per jean

      Labor cost per jean

 

Chinos:

  Materials (cotton twill)

    Price per yard

    Yards per chino

      Material cost per chino

 

  Direct labor

    Wage rate

    Hours per chino

      Labor cost per chino

 

Factory Overhead

 

500,000

500,000

1,000,000

 

 

 

 

$  4.80

x    1.10

$  5.28

 

 

$15.00

    x     0.50

$  7.50

 

 

 

$  4.40

x    1.10

$  4.84

 

 

$15.00

x     0.70

$10.50

 

$3,600,000

 

500,000

400,000

900,000

 

 

 

 

$  5.00

 x     1.00

$  5.00

 

 

$14.00

x     0.40

$  5.60

 

 

 

$  4.50

x    1.20

$  5.40

 

 

$14.00

x    0.75

$10.50

 

$3,300,000

 

Most of this information is available from the previous chapter. Also, the ZFN example in the previous chapter derived the budgeted overhead rate of $6.00 per direct labor hour, and that same overhead rate is used by the standard costing system. Based on this information, the standard costing system would debit the finished goods inventory account as follows:


 

 

Jeans

Chinos

Standard cost per unit:

  Materials

  Labor

  Overhead

 

Actual units produced

  Total

 

$5.28

$7.50

$6.00 x 0.50 = $3.00

$15.78

x    500,000

$7,890,000

 

 

$4.84

$10.50

$6.00 x 0.70 = $4.20

$19.54

x     400,000

$7,816,000

 

Recall from the previous chapter that 400,000 jeans and 350,000 chinos were sold. The entries to record the movement of inventory from the finished goods inventory account into the cost-of-goods-sold account would multiply these sales volumes by $15.78 per jean and $19.54 per chino.

 

 

Reasons for using a Standard Costing System:

There are several reasons for using a standard costing system:

 

Cost Control: The most frequent reason cited by companies for using standard costing systems is cost control. One might initially think that standard costing provides less information than actual costing, because a standard costing system tracks inventory using budgeted amounts that were known before the first day of the period, and fails to incorporate valuable information about how actual costs have differed from budget during the period. However, this reasoning is not correct, because actual costs are tracked by the accounting system in journal entries to accrue liabilities for the purchase of materials and the payment of labor, entries to record accumulated depreciation, and entries to record other costs related to production. Hence, a standard costing system records both budgeted amounts (via debits to work-in-process, finished goods, and cost-of-goods-sold) and actual costs incurred. The difference between these budgeted amounts and actual amounts provides important information about cost control. This information could be available to a company that uses an actual costing system or a normal costing system, but the analysis would not be an integral part of the general ledger system. Rather, it might be done, for example, on a spreadsheet program on a personal computer. The advantage of a standard costing system is that the general ledger system itself tracks the information necessary to provide detailed performance reports showing cost variances.

 

Smooth out short-term fluctuations in direct costs: Similar to the reasons given in the previous chapter for using normal costing to average the overhead rate over time, there are reasons to average direct costs. For example, if an apparel manufacturer purchases denim fabric from different textile mills at slightly different prices, should these differences be tracked through finished goods inventory and into cost-of-goods-sold? In other words, should the accounting system track the fact that jeans production on Tuesday cost a few cents more per unit than production on Wednesday, because the fabric used on Tuesday came from a different mill, and the negotiated fabric price with that mill was slightly higher? Many companies prefer to average out these small differences in direct costs.  

 

When actual overhead rates are used, production volume of each product affects the reported costs of all other products: This reason, which was discussed in the previous chapter on normal costing, represents an advantage of standard costing over actual costing, but does not represent an advantage of standard costing over normal costing.

 

Costing systems that use budgeted data are economical: Accounting systems should satisfy a cost-benefit test: more sophisticated accounting systems are more costly to design, implement and operate. If the alternative to a standard costing system is an actual costing system that tracks actual costs in a more timely (and more expensive) manner, then management should assess whether the improvement in the quality of the decisions that will be made using that information is worth the additional cost. In many cases, standard costing systems provide highly reliable information, and the additional cost of operating an actual costing system is not warranted.

 

 

Summary of Actual Costing, Normal Costing and Standard Costing:

The following table summarizes and compares three commonly-used costing systems.

 

 

 

 

Actual Costing System

 

Normal Costing System

 

Standard Costing System

 

   Direct Costs:

 

(Actual prices or rates x actual quantity of inputs per output) x actual outputs

 

(Actual prices or rates x actual quantity of inputs per output) x actual outputs

 

(Budgeted prices or rates x standard inputs allowed for each output) x actual outputs

 

 Overhead Costs:

 

Actual overhead rates x actual quantity of the allocation base incurred.

 

Budgeted overhead rates x actual quantity of the allocation base incurred.

 

Budgeted overhead rates x (standard inputs allowed for actual outputs achieved)

 

The following points are worth noting:

 

1.                  All three costing systems record the cost of inventory based on actual output units produced. The static budget level of production does not appear anywhere in this table.

 

2.                  Actual costing and normal costing are identical with respect to how direct costs are treated.

 

3.                  With respect to overhead costs, actual costing and normal costing use different overhead rates, but both costing systems multiply the overhead rate by the same amount: the actual quantity of the allocation base incurred.

 

4.                  Normal costing and standard costing use the same overhead rate.

 

5.                  Standard costing records the cost of inventory using a flexible budget concept: the inputs “that should have been used” for the output achieved.

 

There are costing systems other than these three. For example, some service sector companies apply direct costs using budgeted prices multiplied by actual quantities of inputs. For example, many accounting firms track professional labor costs using budgeted professional staff hourly rates multiplied by actual staff time incurred on each job.

 

 

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