Learning Objective 4 Explain why standard costs are often used in variance analysis
standard costs exclude past inefficiencies and take into account expected future changes
To gain further insight, a company will subdivide the flexible-budget variance for its direct-cost inputs into two more-detailed variances:
A price variance that reflects the difference between an actual input price and a budgeted input price
An efficiency variance that reflects the difference between an actual input quantity and a budgeted input quantity
We will call these level 3 variances. Managers generally have more control over efficiency variances than price variances because the quantity of inputs used is primarily affected by factors inside the company (such as the efficiency with which operations are performed), whereas changes in materials prices or wage rates are heavily influenced by external market forces.
Obtaining Budgeted Input Prices and Budgeted Input Quantities
To calculate price and efficiency variances, Webb needs to obtain budgeted input prices and budgeted input quantities. Webb’s three main sources for this information are (1) past data, (2) data from similar companies, and (3) standards. Each source has its advantages and disadvantages.
ACTUAL INPUT DATA FROM PAST PERIODS. Most companies have past data on actual input prices and actual input quantities. These historical data could be analyzed for trends or patterns using techniques we will discuss in Chapters 10 and 11 to estimate budgeted prices and quantities. Machine learning and artificial intelligence models use sophisticated algorithms to make these predictions.
ADVANTAGES: Past data represent quantities and prices that are real rather than hypothetical benchmarks. Moreover, past data are typically easy to collect at a low cost.
DISADVANTAGES: A firm’s inefficiencies, such as the wastage of direct materials, are incorporated in past data. Consequently, the data do not represent the performance the firm could have ideally attained, only the performance it achieved in the past. Past data also do not incorporate any changes expected for the budget period, such as improvements resulting from new investments in technology.
DATA FROM OTHER COMPANIES THAT HAVE SIMILAR PROCESSES. Another source of information is data from peer companies or companies that have similar processes, which can serve as a benchmark. For example, Baptist Healthcare System in Louisville, Kentucky, benchmarks its labor performance data against those of similar top-ranked hospitals.
ADVANTAGES: Data from other companies can provide a firm useful information about how it is performing relative to its competitors.
DISADVANTAGES: Input-price and input-quantity data from other companies often are not available or may not be comparable to a particular company’s situation. Consider Costco, which pays hourly workers an average of more than $20 per hour, well above the national average of $11.50 for a retail sales worker. Costco also provides the vast majority of its workforce with company-sponsored health care. Costco believes that higher wages and benefits increase employee satisfaction, improve productivity, and reduce turnover. But these wage rates are not a relevant benchmark for a company that follows a different labor strategy.
STANDARDS DEVELOPED BY THE FIRM ITSELF. A standard is a carefully determined price, cost, or quantity that is used as a benchmark for judging performance. Standards are usually expressed on a per-unit basis. Consider how Webb determines its direct manufacturing labor standards. Webb conducts engineering studies to obtain a detailed breakdown of the steps required to make a jacket. Each step is assigned a standard time based on work performed by a skilled worker using equipment operating in an efficient manner. Similarly, Webb determines the standard quantity of square yards of cloth based on what is required by a skilled operator to make a jacket.
ADVANTAGES: Standard times (1) aim to exclude past inefficiencies and (2) take into account changes expected to occur in the budget period. An example of the latter would be a decision by Webb’s managers to lease new, faster, and more accurate sewing machines. Webb would then incorporate higher levels of efficiency into the new standards.
DISDVANTAGES: Because they are not based on realized benchmarks, the standards might not be achievable, and workers could get discouraged trying to meet them.
The term standard refers to many different things:
A standard input is a carefully determined quantity of input, such as square yards of cloth or direct manufacturing labor-hours, required for one unit of output, such as a jacket.
A standard price is a carefully determined price a company expects to pay for a unit of input. In the Webb example, the standard wage rate the firm expects to pay its operators is an example of a standard price of a direct manufacturing labor-hour.
A standard cost is a carefully determined cost of a unit of output, such as the standard direct manufacturing labor cost of a jacket at Webb.
STANDARD DIRECT MATERIAL COST PER JACKET: 2 square yards of cloth input allowed per output unit (jacket) manufactured, at $30 standard price per square yard
STANDARD DIRECT MANUFACTURING LABOR COST PER JACKET: 0.8 manufacturing labor-hour of input allowed per output unit manufactured, at $20 standard price per hour
How are the words budget and standard related? Budget is the broader term. To clarify, budgeted input prices, input quantities, and costs need not be based on standards. As we saw previously, they could be based on past data or competitive benchmarks. However, when standards are used to obtain budgeted input quantities and prices, the terms standard and budget are used interchangeably. For example, the standard-cost computations shown previously for direct materials and direct manufacturing labor result in the budgeted direct material cost per jacket of $60 and the budgeted direct manufacturing labor cost of $16 referred to earlier.
In its standard costing system, Webb uses standards that are attainable by operating efficiently but that allow for normal disruptions. A normal disruption could include, for example, a short delay in the receipt of materials needed to produce the jackets or a production hold-up because a piece of equipment needed a minor repair. An alternative is to set more-challenging standards that are more difficult to attain. As we discussed in Chapter 6, challenging standards can increase the motivation of employees and a firm’s performance. However, if workers believe the standards are unachievable, they can become frustrated and the firm’s performance could suffer.